Standby LCs: Banks need to develop cetralised expert teams

Nironjan Roy from Toronto, Canada | Published: April 10, 2019 19:59:00

Picture used for illustrative purpose only

Evergreen Standby LC bears a very critical risk of receiving non-renewal notice from the bank that issued counter Standby LC after the extension of local Standby LC under auto-renewal clause. If such situation unfortunately arises, the entire risk falls on the issuing bank of local Standby LC. This is undoubtedly a very complex structure and therefore, experience and clear understanding about the product and the risk there under are required to properly manage this Standby LC. However, a simple equation can help reduce the operational risk of Standby LC that has both auto-renewal and exit clauses. This ensures that the gap between non-renewal notice period of local Standby LC and counter Standby LC must be at least 15 days longer than the window between the expiry of local Standby LC and counter Standby LC.

For example, if a local Standby LC expires on April 30, 2020 with auto renewal clause and 30 days of non-renewal notice period while counter Standby LC expires on June 30, 2020 with auto-renewal clause and 90 days non-renewal notice period, the gap between non-renewal notice and auto-renewal is 60 days, while the window between two expiry dates is also 60 days. So the risk of local Standby LC is not mitigated at all because gap and window are equal. If similar local and counter Standby LCs are issued with non-renewal notice period of 60 days and 90 days respectively, this risk will not be mitigated. Rather, it will be highly exposed. This is because the gap is only 30 days while the window is 60 days. As a result, there is high risk of receiving non-renewal notice from counter Standby LC issuing bank after local Standby LC is extended for another year. If and only when similar local and counter Standby LCs are issued with non-renewal notice period of 30 days and 120 days, operational risk associated with local Standby LC will be mitigated because the gap is 90 days, which is 30 days longer than the 60 days window between expiry of both Standby LCs.  Under this situation, issuing bank of local Standby LC has no risk at all because they will have enough time to act on their local Standby LC if they receive non-renewal notice from the counter Standby LC issuing bank. 

PERPETUAL STANDBY LC AND MITIGATING ITS RISK: Perpetual Standby is basically a regular Standby LC without any stated expiry. This is also known as open-ended Standby LC. In some exceptional cases, particularly where the beneficiary is a government entity, issuance of perpetual Standby LC is required and termination clause is assigned in order to reduce the risk of open-ended Standby LC. The termination clause clearly states that Standby LC may be cancelled at any time upon issuance of three months/six months prior notice as stipulated in that clause and open-ended Standby LC is terminated after that notice period has elapsed. However, if termination clause in an open-ended Standby LC exists, beneficiary usually demands additional claim period ranging from one to five years as required for underlying transactions. The risk for this complicated structure must be assessed with professional approach and due diligence. Local Standby LC is issued without fixed expiry whereas counter Standby LC is mostly issued with fixed expiry with auto-renewal clause to cover the risk of open-ended local Standby LC. In order to mitigate the risk of issuing non-renewal notice, counter Standby LC should contain a drawdown clause that allows the beneficiary, issuer of local Standby LC, to draw and retain the fund if local Standby LC remains outstanding.

UNFRETTED DRAWDOWN CLAUSE IN STANDBY LC:  Simple drawdown clause only ensures protection against receiving non-renewal notice of counter Standby LC. But it does not allow the issuing bank of local Standby LC to exit the transaction. So, this kind of risk is mitigated by incorporating unfretted draw down clause that unequivocally states that issuer of local Standby LC may issue termination notice at its sole discretion and thus can draw under counter Standby LC to retain the fund as long as their obligation under local Standby LC remains valid. Fund drawn and retained will be used to honour claim, if received under local Standby LC. Otherwise, it will be returned to the issuing bank of counter Standby LC. Usually, bank is reluctant to issue this type to Standby LC but they cannot help issuing open-ended Standby LC when a government agency is involved and where there is huge business opportunity. Further, there are some jurisdictions and countries where local law and regulations allow the beneficiary of Standby LC additional time even after the stated expiry to lodge claim against Standby LC. This risk should also be taken into consideration while issuing Standby LC. El Salvador has local regulation that exclusively allows the beneficiary of Standby LC additional three years time to claim.

STANDBY LC & BANKS' RISK APPETITE: Local Standby LC is issued against counter Standby LC, so the former is governed by the contents of the latter. If the text of the counter Standby LC does not allow the issuing bank of local Standby LC to unilaterally issue non-renewal notice for their instrument, this exit clause cannot be exercised. Exit clause of local Standby LC is only exercised, when similar clause in counter Standby LC is applied. If this is not meticulously followed, the risk undertaken by the issuing bank of local Standby LC cannot be mitigated. Issuing bank of local Standby LC will have to honour the claim received against their instrument but will not receive their claim from the issuing bank of counter Standby LC. As Standby LC involves various parties related to underlying transaction and counterparty banks, unilateral decisions of exiting the Standby LC can strain the relationship between the different parties. Prior to undertaking Standby LC, all relevant factors including bank's risk policy, risk appetite, risk tolerance must be taken into consideration.   

AML, ATF & SANCTIONS RISK: Compliance risk of Money Laundering (ML), Terror Financing (TF) and Sanction violation has now become a very challenging task for all banks across the world. Banks from both developed and developing countries have been struggling against ML and TF crimes. Usually, cross-border transaction exposes higher ML, TF and Sanction violation risk than all other regular businesses. However, ML, TF and Sanction violation is relatively less for Standby LC because mostly government agencies and large corporate houses are found to be the parties of Standby LC. So, their risk factors are very low. Moreover, MTA (Master Trade Agreement) is executed between two trading partners whose risk factors are well assessed over a period of time. Nevertheless, there is risk of ML, TF and Sanction violation in undertaking Standby LC. So, proper screening process should be given equal weight. Further, Standby LC, if drawn immediately after, can expose higher risk of ML and TF. Like all other banking services, Standby LC also bears the risk of ML, TF and Sanction violation. Hence, the bank must ensure that proper screening process is in place for adequately mitigating compliance risk.        

RELEVANT LAWS: Since Standby LC is governed by international rules, regulation and local laws as well, bankers responsible for dealing with this trade finance product must be very familiar with relevant laws. In general, ICC rules particularly ISP - 98 (International Standby Practice), URDG 758 (Uniform Rules for Demand Guarantee) and UCPDC - 600 (Uniform Customs and Practice of Documentary Credit) apply to Standby LC. Besides, local law and regulations of the jurisdiction where Standby LC is issued is also important in dealing with this instrument. Furthermore, underlying transaction plays an important role in the operation of Standby LC. This underlying transaction is again governed by contract law. Familiarisation with this law is equally important. Since Standby LC is drafted with legal language, the person responsible for reviewing this instrument should be comfortable in understanding legal language. Relevant laws prevailing in the local jurisdiction of issuing bank will always apply and even supersede all other laws, even ICC rules.

CENTRE OF EXCELLENCE SHOULD HANDLE STANDBY LC: No bank in the world deploys professionals of high level to manage Standby LC and this is not even required at all in the online banking era. Bank is required to ensure that their business centres responsible for providing Standby LC services is adequately staffed with officers having minimum knowledge. For expert advice, bank maintains a centralised team, called Centre of Excellence. This provides all types of expertise on the said bank's Standby LC business. This department is comprised of efficient bankers who are very knowledgeable and conversant about Standby LC. The core responsibility of this department is to thoroughly review Standby LC, assess bank's operational and reputational risk and mitigation scope prior to undertaking Standby LC. This team even prepares text of the Standby LC to be issued by the bank. They also examine the content of Standby LC issued by other banks and suggest necessary amendment thereof to ensure that the instrument is free of operational risk and can be accepted. As soon as bank's business centre receives any request for Standby LC, a copy of this is immediately sent to the Centre of Excellence Team for thorough review. Based on their findings, they either approve or suggest necessary correction. Once the business centre receives clean approval from the Centre of Excellence, they can act on the Standby LC. 

Nironjan Roy is a banker, based in Toronto, Canada.

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