Risk management is based on a thorough understanding of business processes and practices, and successful risk management programs incorporate risk mitigation principles.
Risk mitigation is the actual anticipation of risk—that is, being able to predict, somewhat, where things could go wrong and taking preventative steps to minimize or avoid that risk from becoming reality, thereby avoiding potentially dire consequences.
In the context of being paid for goods sold to a foreign buyer, a company may adopt a risk mitigation strategy that uses a more secure method of payment, such as letter of credit (LC), also known as a documentary credit. In this article we are only considering the risks of LC's issued by banks, in the context of pre-contractual negotiations to ensure that payment is received as expected.
The LC is a very complex instrument because of the number of parties involved, the mechanics of its operations, and the rules governing the transaction. The Uniform Customs and Practice for Documentary Credits (UCP 600), effective July 1, 2007, are the applicable rules devised by the International Chamber of Commerce and adhered to by banks worldwide.
It is important to note that the UCP 600 are neither an international convention nor a body of law. In fact, legislation specific to LC's exists only in the minority of countries, and the application of such laws varies widely in its scope: from the U.S., believed to have the most detailed and comprehensive legislative coverage through Article 5 of the Uniform Commercial Code, to countries like Australia and South Africa, which do not have specific legislation at all. That is why banks rely on the LC rules: the UCP 600.
The attraction of a letter of credit is in the perceived security the LC provides as a method of payment. Essentially, in LC trade, a seller (exporter) substitutes the credit risk of the buyer (importer) with that of the buyer’s bank (issuing bank).
When the issuing bank releases the credit to the exporter (the beneficiary), it provides an undertaking to pay, provided all terms and conditions of the LC have been met, and that documentation with specified data content is submitted in a timely fashion. This gives rise to the conditional guarantee of payment.
Because of the relative payment safetythe LC provides, exporters regard it particularly useful in high-value transactions and comparatively higher-risk transactions. It is simply not worth using the LC for small-value transactions as banks charge fees, which are usually a percentage of the transaction value. There is no standard fee applicable to L/ business, with great variation in bank fees from one country to another.
LC’s are not risk free, and the exporter must consider the country risk and the bank risk prior to entering into a sales contract with the buyer.
In a climate where the world’s financial markets are in turmoil, the assessment of country risk becomes increasingly important when engaged in international trade transactions. Credit ratings often make it to the news, especially when negative events occur.
There are a number of theoretical models that have been developed for country risk assessment, by a variety of organizations, but one of mostly highly regarded and relied upon is the one developed by the Organization for Economic Co-Operation and Development (OECD). Details of this may be found at the OECD website.
The OECD Country Risk Classification Method measures country credit risk, that is, the likelihood of a country to service its external debt. The classification is achieved by two methods:
There are eight country risk categories from 0 (least risk) to 7 (highest risk). The final classification is based on the decision of the country risk experts from the participating export credit agencies.
This classification is used by export credit agencies when considering whether to insure export business against the likelihood of country default. Banks also use this classification in their decision-making process related to international trade transactions. The classification is periodically updated, so exporters should be checking the OECD website to remain up-to-date with changing country risk profiles.
It is important to consider country risk because the government of the foreign country ultimately controls the outflow of funds. In some countries restrictions are minimal, if any. In the more marginal (therefore more risky) economies, a degree of control is applied, with LC’s typically issued by central banks.
The reason a company might not be getting paid under a LC may not necessarily rest with the bank refusing payment, but rather the foreign government may have imposed restrictions. It has been known for governments to impose payment moratoriums on foreign purchases from time to time.
The UCP 600 do not override sovereign government decisions. If the government’s credit risk is questionable, great care must be taken to craft the appropriate payment safeguards. These actions must be pre-emptive, that is, prior to the formation of the contract, so as to avoid possible financial losses.
Given that the undertaking to pay comes from the issuing bank, the exporter must ensure that the bank is indeed creditworthy. After all what is the point of obtaining a payment guarantee if that guarantee cannot be relied upon.
An effective means to enhance the security of payment is to trade on the basis of a confirmed letter of credit. When a LC is confirmed, the undertaking to pay (and the credit risk) is shifted from the issuing bank to the confirming bank.
The apportionment of credit risk across the different methods of payment is shown in Table 1 below. Please note the shifting of risk according to the different payment arrangements.
|
Payment method |
Exporter Risk |
|
Prepayment |
There is no credit risk for the exporter once cleared funds have been received, as the sales proceeds are collected ahead of shipping the goods. |
|
Non-LC Trade:
|
The buyer presents as the credit risk, as there is no independent guarantee of payment. |
|
L/C - not confirmed |
The issuing bank in the foreign country presents as the credit risk, as this is where the payment guarantee comes from. The buyer’s risk is therefore substituted with that of the issuing bank. |
|
L/C Confirmed |
The confirming bank presents as the credit risk, as this is now where the payment guarantee comes from. The issuing bank’s credit risk has been substituted with that of the confirming bank. |
There are several options available for L/C confirmation to be effected:
Confirmation means that the payment undertaking given by issuing bank is further underwritten by the confirming bank—a guarantee on a guarantee, if you like.
Any bank can be the confirming bank, including the issuing bank. This is just simply dangerous and unacceptable from a risk mitigation aspect. Where the issuing bank confirms the credit, the payment security is not enhanced at all as the same bank that provides the payment guarantee (issuing bank) is guaranteeing itself!
This is not a good option.
Some export credit agencies claim that 90% of defaults in export trade are due to country risk matters. If there is perceived risk in dealing with the issuing bank, invariably there is an element of country risk associated with this. Having the LC confirmed by another bank in the same country does nothing to alleviate the country risk elements.
This is not a good option.
Where the LC is confirmed outside the country of issue, there is a different country risk profile. The trick is to make sure that the country of confirmation is acceptable. There is no point in having the LC confirmed by a bank in a basket case country. Again we return to the issue of risk mitigation and the creditworthiness of the party giving the payment guarantee.
Therefore we need to specify the country in which we wish to have the LC confirmed. The best option would seem to be for the exporter to request the LC be confirmed through a bank in their country, or better still, their own bank.
This is a good option, as we should be reasonably certain about our domestic bank’s credit risk profile.
Where trading relationships are delicate and the exporter believes the buyer may be insulted by being asked to provide a confirmed LC (this being regarded as a sign of mistrust), the exporter can seek independent silent confirmation. This means such confirmation will be undertaken between the exporter and the confirming bank (usually the exporter’s bank) without the buyer’s or the issuing bank’s knowledge.
The matter does not end here. Although the seller can ask for a confirmation of a LC, there is no obligation for that bank to give it under the UCP 600 rules. In other words, confirmation of a LC is not automatic.
Just like an exporter wishes to minimise their credit risk, so does a bank. The bank being requested to confirm a LC will pursue due diligence processes and, having evaluated the credit risk profile of the issuing bank, the country in question, and the details of the transaction, will decide whether or not to confirm.
What should the exporter do to minimise payment default on a LC?
This is payment insurance that may be available through a government trade facilitation agency and/or private insurers. There are limitations to such credit insurance contacts. The insurer will need to know ahead of time details of the country, the buyer and the bank involved before deciding whether or not to insure.
Premiums for credit insurance vary across the different risk profiles. Usually the exporter is not able to obtain full reimbursement for any loss incurred. Some credit insurance agencies offer a maximum reimbursement ceiling of 85% against any one claim. So if your deal was worth USD 100,000 and there was default on payment, you would only be entitled to receive USD 85,000 maximum.
Depending on the circumstances, therefore, credit insurance may not be an answer to all your credit risk problems.
Prior to the sales contract being executed, obtain from the buyer a draft of the LC terms and conditions, including details of the issuing bank.
Ask the buyer whether they are willing to have the LC confirmed and whether they are willing and able to have this done in a third country (preferably in your country).
Seek advice from your bank as to whether they would be willing to confirm the LC. If the answer is negative, the exporter should not proceed. If your bank thinks this is not a good risk, neither should you.
Finally, the exporter needs to consider the time period given to the buyer for payment. Although supplier credit is commonplace, this is one of the elements that contributes to the whole of the credit-risk profile. It is generally accepted that the longer the payment term, the higher the risk, and the LC is no safeguard against changing fortunes in a foreign country’s economic or political landscape.
As much as possible, the exporter is encouraged to seek payment at the earliest possible time. At times, an inducement to do this is required.
Do the math. Perhaps giving a small discount to obtain payment earlier will be more than offset by the reduction in credit risk exposure coupled with savings from having to service the sale for a shorter period of time. It’s all about cash flow.