International trade: Limitations of traditional banking  

MS Siddiqui in the first of his two-part article titled 'Innovative trade finance service' | Published: May 20, 2018 22:31:51 | Updated: May 22, 2018 21:03:05

Globalisation and global value chain have increased the importance of international trade over the last few decades. These have accelerated international trade with trade facilitation and reduction in trade barriers. Banks are in business of short-term loans consisting mostly of trade finance, medium-term loans stretching for about one to five years and long-term loans for more than five years that can be used for financing import and export of capital goods such as machinery, equipment etc. International trade in the context of Bangladesh is mostly involved in the businesses of banks.

Payment is a major issue in international trade. Banks have methods of payment designed to help importers and exporters mitigate the credit risk inherent in the purchase and shipment of goods, largely by using commercial documentary letters of credit (L/C). The traditional terms of payment, such as L/C, have been partially replaced by more favourable methods for buyers and sellers. One of those is open account basis, which is less costly and less cumbersome than commercial documentary L/C without any collateral.

These new products are also designed to extend loan to either or both parties in transaction. Small suppliers can have difficulty obtaining the capital needed to support their businesses with supply chain financing and receivables financing can provide a source of working capital for those firms.

Most of the banks in developing countries are relatively smaller in global context. They usually rely on foreign correspondent banking relationships to facilitate the trade activities required by their clients. These correspondent relationships with other banks are done to provide services that can be performed more economically or efficiently because of the other bank's size, expertise in a specific line of business, or geographic location. Some banks built on this relationship provide an unsecure, revolving line of credit to the foreign bank that is then recycled as an operating loan to a local importer or exporter.

Standby L/C and commercial L/C are two major types of documentary credits that banks in Bangladesh may offer to finance their clients' international trade transactions.

LETTERS OF CREDIT (L/C): Most banks, regardless of size or complexity, issue L/C on behalf of their clients. In some countries, including Bangladesh, L/C is a mandatory instrument for overseas transaction with few exceptions. An L/C gives the beneficiary increased assurance that the promised payment(s) will be honoured. In essence, the issuing bank of L/C increases the credibility of its client. Commercial documentary L/C and standby L/C are the two broad types of L/Cs that banks use to facilitate trade finance.

COMMERCIAL DOCUMENTARY L/C: The commercial documentary L/C is commonly used to finance a commercial contract for the shipment of goods from seller to buyer. This versatile instrument may be used in nearly every type of trade finance transactions and provides for instant payment to the exporter when the goods are shipped and conforming documents are presented to the bank. According to the Uniform Commercial Code (UCC), all L/Cs must be issued in favour of a specific beneficiary (the exporter), for a specific amount of money, in a form clearly stating how payment to the beneficiary is to be made and under what conditions and with a specific expiry date.

The issuing banks open import L/C with the bank of exporter who treats this export L/C. They reflect different positions of an importer and exporter in the use of the same L/C for a transaction.

To the importer, L/C allows the issuing bank to substitute its creditworthiness with that of the client, i.e., the importer. Following a client's request, the issuing bank pays a stated sum of money to the exporter(s) against stipulated documents - thereby transferring ownership of the goods. An L/C does not guarantee the efficiency or performance of exporter and it is not a guarantee of quality of supplies since the bank deals only in documents and does not inspect the goods themselves.

The exporter may also request additional confirmation if they do not find the issuing bank acceptable. Exporters study the credit rating and performance records of the L/C issuing bank. The confirming bank then becomes directly obligated to the exporter as if it were an issuing bank and has rights, obligations, and risks, if any, with respect to the issuing bank as if the issuing bank were an L/C applicant. There are many banks in Bangladesh with lower creditworthiness and acceptability to the overseas bankers.

As banks are used to dealing only with documents, the overall success of a commercial L/C transaction depends heavily on the documents' credentials and resolution of discrepancies. This contains various documents and certificates and failure to strictly ascertain complaints may cause discrepancies and payment may be held up thereafter.

A single transaction requires many different types of documents, and failure to obtain conforming documents or to resolve document discrepancies, especially the material errors, may cause the bank to lose its protection and rights and result in financial losses.

Payments under a commercial L/C do not necessarily lead to an extension of credit. The bank pre-arranges with the client a method by which the L/C will be funded - normally by a debit to an existing bank account or by using a preapproved credit facility.

STANDBY L/C: A standby L/C is another form of letter of credit, but not available in any bank operating in Bangladesh. It is common in many countries where it is used for trade finance. The standby L/C is a bank guarantee of payment, which is close to documentary L/C except for one exception: it is only a guarantee of payment and not any means of payment. Standby L/C is typically issued by a bank undertaking to pay one party (the beneficiary) to a contract when the other party fails, or is alleged to have failed, to perform the contract. The beneficiary is usually the purchaser of goods or services under the contract. A standby L/C is often payable simply on the beneficiary's presentation of a written demand. Hence, a standby L/C is not used to finance the purchase or shipment of goods, but as an international trade guarantee.

GUARANTEES: Banks are also in business of providing guarantee of performance of their clients to others in some categories of contracts. A guarantee applies when the bank's given security is not reliant on the existence, validity and enforceability of the main obligation. A bank guarantee is a guarantee from the bank thereby ensuring that the liabilities of a debtor will be met. In other words, if the debtor fails to settle a debt, the bank covers it. A bank guarantee enables the customer, or debtor, to acquire goods, expand production capacity or obtain loans from home and abroad, and expand business activity.

Performance guarantee, finance guarantee, deferred payment guarantee etc are types of guarantee commercial banks issue for their clients. A bank acts as the guarantor for an obligation owed by debtor's performance of a service or any other agreed obligation by issuing guarantee or bond. With this promise, bank undertakes to pay a maximum specified amount when conditions of the guarantee/surety bond are met through failure of customer stipulated in the deed. As well as issuing guarantees and surety bonds, banks also offer advice for guarantees from third-party banks. Such third-party guarantee usually occurs in international trade. As part of such service, bank gauges authenticity of the guarantee and advises the beneficiary (recipient of the guarantee) about any point seems unclear.

One of the regular guarantees in international trade is on the bill of exchange. The guarantee is considered to be in favour of the party issuing the bill of exchange. The guarantor becomes jointly liable with the drawee. As guarantor, bank undertakes to promptly pay a bill of exchange in favour of specified party. The standard condition is that the bill of exchange must be payable at the guarantor bank.

Some other typical bank guarantees are:

n bid bond that prevents companies from tendering bids and not accepting or executing the awarded contract;

n performance bond that serves as collateral for the buyer's costs incurred if services or goods are not provided as agreed in the contract;

n advance payment guarantee that acts as collateral for reimbursing advance payment from the buyer if the seller does not supply the specified goods as per the contract

n warranty bond that serves as collateral ensuring that the ordered goods are delivered as agreed etc.

The prevailing rules and regulations in Bangladesh do not permit standby L/C, open account transactions and some categories of guarantees, which are widely used to facilitate international trade in other countries. In fact, the banking system in Bangladesh follows traditional banking business in case of L/C and small trade finance such as deferred L/C against mortgage and security. But the modern banking system offers credit without traditional non-movable asset security.

MS Siddiqui is a legal economist.

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