What it means
The instrument replaces trust in a counterparty with trust in a bank. A landlord, a supplier or a project owner who is not comfortable relying on a company's balance sheet will accept the credit standing of a large bank instead, and the bank charges a fee for lending its name.
If the customer performs as promised, the standby expires unused and the only cost is the fee. Drawing on a standby is deliberately mechanical.
The beneficiary presents specified documents, usually a signed statement that the customer has defaulted, and the bank must pay against those documents without investigating whether the underlying dispute is fair. That independence is what makes the instrument valuable to the beneficiary and slightly uncomfortable for the applicant, who can face payment while still arguing about the contract.
Standbys fall broadly into financial and performance types. A financial standby backs a payment obligation, such as rent, insurance deductibles or a loan, while a performance standby backs the delivery of work to a required standard, which is common in construction and large equipment contracts.
The wording of the drawing conditions matters far more than the label. The cost has two parts that businesses often underestimate.
There is an annual fee, commonly somewhere between 0.5% and 2% of the face amount depending on credit quality, plus issuance and amendment charges, and there is the effect on borrowing capacity, because the bank counts the standby against the customer's overall facility and may require cash collateral. A $3,000,000 standby can quietly remove $3,000,000 of headroom from a company's ability to borrow elsewhere.
Two features cause most of the operational problems. Standbys are usually issued for a fixed term with an evergreen clause that renews them automatically unless the bank gives notice, so they can persist long after the underlying contract ends, and the original document sometimes has to be physically returned before the facility is released.
Keeping a register of live standbys, their expiry dates and their release conditions is basic treasury hygiene.
In practice
Real-world examples
Example 1
A growing logistics company signs a ten year warehouse lease and the landlord asks for a deposit of twelve months' rent, $840,000. The company provides a standby letter of credit instead, keeping the cash in its own business and paying an annual fee of about $12,600 at a 1.5% rate.
Example 2
An engineering firm bidding for an overseas water treatment plant must post a performance standby for 10% of the contract value. The client can draw on it if milestones are missed, which gives the client comfort and gives the firm's bank a strong interest in monitoring project progress.
Example 3
A mid sized insurer requires a manufacturer to secure its self insured retention on employer liability claims. A standby letter of credit for $1,500,000 satisfies the requirement without the manufacturer depositing funds with the insurer.
Think of it
A standby letter of credit is like having a wealthy, highly respected friend stand behind you at a car dealership and tell the seller, 'Let them drive the car home. If they miss a payment, send the bill to me.'
Formula
Calculation
Annual standby fee = face amount x fee rate
Total cost = annual fee x number of years + issuance and amendment charges
A contractor is required to provide a standby letter of credit for $2,000,000 to secure a two year supply agreement. The bank quotes a fee of 1.5% a year plus a one off issuance charge of $1,500.
The annual fee is $2,000,000 x 1.5% = $30,000, so over the two year term the fee cost is $30,000 x 2 = $60,000. Adding the issuance charge gives a total cash cost of $60,000 + $1,500 = $61,500.
The bank also requires 25% cash collateral, which is $2,000,000 x 25% = $500,000 tied up in a blocked account for the two years. If that cash would otherwise have earned 4% a year, the opportunity cost is $500,000 x 4% x 2 = $40,000, bringing the true economic cost of the standby to $61,500 + $40,000 = $101,500 over the two years.Case study
Seen in the real world
The following is an illustrative and fictional example. Cardington Modular Buildings, an invented construction business, won a $12,000,000 contract to supply school classrooms, subject to providing a performance standby letter of credit for $3,000,000 covering an 18 month build programme.
Its bank issued the standby at 1.2% a year, so the annual fee was $3,000,000 x 1.2% = $36,000 and the 18 month cost was $36,000 x 1.5 = $54,000. Against a budgeted margin of 8% on the contract, or $12,000,000 x 8% = $960,000, the fee absorbed $54,000 / $960,000 = 5.6% of the expected profit, which the estimating team had not built into the price. The bank also required 30% cash cover, freezing $3,000,000 x 30% = $900,000 for the duration.
The bigger surprise came 20 months later. The standby carried an evergreen clause and had renewed automatically because nobody had asked the client to release it on practical completion, so the fictional company paid a further $36,000 and kept $900,000 blocked for an extra year. Cardington's response was to build standby fees into every tender price and to maintain a register of live instruments with diary reminders 90 days before each renewal notice deadline.
Watch out
Common mistakes
- Assuming the bank will investigate the merits of a dispute before paying, when it must pay against conforming documents regardless of the underlying argument.
- Ignoring the effect on borrowing capacity, since an unused standby still consumes facility headroom and often requires cash collateral.
- Overlooking the evergreen renewal clause, so the instrument and its fees continue long after the contract it secured has finished.
Questions
People also ask
What is the difference between a standby letter of credit and a bank guarantee?
Commercially they do much the same job, though standbys are typically governed by letter of credit rules and are more common where American practice dominates, while guarantees follow different rule sets and are more common in Europe.
How is a standby different from a commercial letter of credit?
A commercial letter of credit is the intended payment mechanism for a trade shipment and is expected to be drawn, whereas a standby is a backstop that is drawn only on default.
Does a standby appear on the balance sheet?
Not as a liability while it is undrawn, but it must be disclosed as a contingent liability in the notes, and the bank treats it as exposure when assessing the customer.