What it means
Avalization is one of the oldest credit devices in trade finance. When a seller doubts a buyer's promise to pay, a bank can add its own signature, the aval, to the bill of exchange.
From that moment the bank stands behind the obligation as surely as if it had borrowed the money itself. The signature changes everything about the paper's value.
A bill backed only by a little-known importer trades at a steep discount, if it trades at all, while the same bill avalized by a respected bank becomes near-cash because the holder now claims against the bank regardless of what happens to the buyer. In markets with active bill-discounting, the avalized bill becomes a short-term investment in its own right.
The aval is distinct from an endorsement. An endorser transfers the bill and takes secondary liability along the chain, while the avalizing party adds a guarantee for someone else's debt, usually signing for the honour of the obligor.
The guarantor pays on default and then pursues the party it protected. European civil law developed the aval formally, and the practice is strongest where bills of exchange remain living instruments.
The 1988 United Nations Convention on International Bills of Exchange and International Promissory Notes devotes a section to guarantees and avals, giving the device an international legal frame. Avals appear most often where supplier credit lubricates trade, because an exporter shipping on open account or against a draft wants comfort stronger than a new customer's word without the paperwork of a full documentary credit.
Fees for avalization resemble guarantee pricing. The bank appraises the obligor as it would for a loan, takes a commission, and books the aval as a contingent liability against its capital, setting limits per customer and aggregating avals with loans and letters of credit when measuring total exposure.
Weaker customers pay more, and some are refused, because the aval is a loan in everything but name, so a customer who uses avalization heavily is borrowing the bank's balance sheet by another route. For managers buying or selling on trade credit, the practical use is negotiation power.
A supplier who accepts an avalized bill gets bank-grade security without letters of credit or cash in advance, and the buyer preserves working capital, at the cost of the bank's fee plus the credit line the aval consumes. Documentary alternatives have eroded the practice in some markets, but avals survive wherever bills of exchange are discounted, and treasurers should compare the device with standby letters of credit, demand guarantees and credit insurance when structuring cross-border sales.
In practice
Real-world examples.
Example
An importer's bank avalizes a trade bill, letting the supplier sell it immediately at a fine discount rate. The supplier gets cash within days instead of waiting six months for the buyer.
Example
A holding company avalizes a subsidiary's promissory note so the subsidiary can refinance at a lower cost. The lender prices the note off the parent's stronger credit.
Example
A holder of an avalized bill claims payment directly from the guaranteeing bank when the issuer defaults at maturity. The bank pays and then pursues the original obligor.
Formula
Calculation
Aval fee = face value of the bill x annual commission rate x (months / 12). The fee is usually quoted like a guarantee commission.
Example: a bank charging 2% a year on a $500,000 bill avalized for six months earns $500,000 x 0.02 x 6/12 = $5,000. For the supplier, suppose the avalized bill is discounted at 6% a year for six months: the discount is $500,000 x 0.06 x 6/12 = $15,000, so the supplier receives $485,000. If the same bill, backed only by a weak buyer, would have been discounted at 12%, the discount would be $30,000 and the proceeds $470,000, so the aval lifts the supplier's proceeds by $15,000 for a $5,000 fee.Case study
Seen in the real world.
This is a fictional, illustrative example. A machinery exporter's new customer cannot open a letter of credit in time for shipment. The customer's bank avalizes the six-month bill for a fee, the exporter discounts it at its own bank for cash, and the machinery ships on schedule. In this illustrative story, the exporter's finance manager notes that the customer's bank counted the aval against the customer's credit lines. The customer had to reduce another borrowing facility to make room, which is the hidden cost of the device, and the manager factors it into future pricing.
Watch out
Common mistakes.
- Treating an aval as a lightweight comfort. The guarantor is fully liable for payment, so banks appraise and price it like a loan and record it as a contingent exposure.
- Confusing an aval with an endorsement. Endorsement transfers the bill down the chain; an aval adds a guarantee for another party's obligation.
- Ignoring what the aval consumes on the obligor's side. The guaranteed amount typically counts against the customer's credit lines, reducing room for other borrowing.
Questions
People also ask.
Who usually avalizes a bill?
A bank or occasionally a financially strong company, signing the bill to guarantee payment for the original obligor.
Is an aval legally recognised internationally?
Yes in many jurisdictions. The 1988 UN convention on international bills and notes expressly regulates guarantees and avals.
How is an aval different from a letter of credit?
Both substitute bank credit for buyer credit, but the aval attaches to a specific bill of exchange, while a letter of credit is a separate documentary undertaking.
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