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Managing Risks in Letter of Credit Business Transactions

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As businesses grow, so do their transactions, and this could include international transactions. To facilitate these international transactions, one of the most common approach is a Letter of Credit (LOC). Find out what it actually entails. Learn how it can help you – and what risks are associated with it. Take approaches to manage these risks towards ensuring sustainable growth of your business in Indonesia.

Letter of Credit: An Overview

A letter of credit (LOC) is issued by a bank to guarantee payment to a seller from a buyer. An LOC comes with its own set of requirements that entitle the seller to this payment. If a buyer fails to pay, the bank would cover the amount needed to pay the seller. This way, the bank acts as the payment's guarantor. When an LOC's requirements are met, payment would always be credited to the seller, ensuring that these sellers would not experience loss of income.

In international trades, a letter of credit is useful as rules and laws of each country can be different. For example, the time and process needed to credit payments may vary. This way, a letter of credit serves as an agreement that as long as terms are upheld and followed, payment would be credited on the agreed time.

There are, however, some drawbacks of using a letter of credit as a means to receive international payment:

Country/political risk

As a letter of credit involves businesses in different countries, it is dependant on the states of these countries. If an involved country changes their policy or laws of payments or are experiencing political turmoil such as conflicts or boycotts, terms of an LOC may not be met. This could cause payments to be delayed. The 2011 Libyan Civil War is a good example of this.

Fraud risk

While banks will always try their best to make sure that every party’s background is checked, frauds could still take place. Fake documents are not new and sometimes these can be used by irresponsible parties when making their case to the bank issuing the LOC.

If, for example, these documents are passed through by the bank as they look to be in compliance with the LOC’s terms and requirements, the bank will honor the LOC. As a result, the applicant of the LOC still have to pay the issuing bank despite the goods/funds that they would never receive.

Exchange rate risk

Exchange rates change every day. Since an LOC involves different parties in different countries, the fluctuation of exchange rates provides another risk. Both the applicant (buyer) or the beneficiary (seller) could suffer loss due to this.

Manage your Risks: Approaches

Every business of any size is exposed to risks. However, risks can still be managed accordingly. As we go further into LOCs and have learned about the potential risks that may go with them, here are some solutions to help manage those risks.

Special guarantees/standby LOCs

Tailored solutions and more customed approaches like special guarantees/standby LOCs could help your business get the payment it deserves. Especially useful when dealing with a new partner that you have not established a relationship with, a guarantee enables you to negotiate favourable payments while fulfilling your financing needs.

Some of these may even include up-front payments and performance definition to reduce the risk of fraud. Whether as a supplier or a buyer, your business is now better protected.

Forfaiting

To take up forfaiting is to protect your business and manage risks at the same time, while not hindering your ability to finance it. Through imports and exports forfaiting, you can improve your financial statements and limit risks at the same time.

This way, your business can stay ahead of its competitors while having its financing needs secured. As a seller, you do not need to wait longer for payment. As a buyer, obtain financing at a lower cost - this will help you get the goods that you need now while paying the seller at a later date. Early payment means you get a fair, current exchange rate than having to worry about fluctuations at a later date.

Other risk management solutions

Other risk management solutions are available in the business banking world. If guarantees and forfaiting do not work for you, these are other alternatives that may be beneficial for you:

Commodities & Structured Trade Finance

As a growing business that is expanding into the global market, you can apply for various trade financing solutions such as the pre-export and prepayment finance. With additional services provided by your bank, like a specialized product and financing team, it has now become easier to secure financing if you are in the commodities industry.

Exporting Solutions

Gain more control over exports and assess and manage emerging international markets risks better. You can now be paid on time, even when your customers may fail to perform payments. Your bank may also offer out loans to help your business improve its cash flows.

Importing Solutions

Streamline the access to your working capital and establish strong business relationships with your suppliers/the sellers. By taking this alternative approach, your bank will pay your suppliers for you even when it is your first time working together with them. Importing solutions also protect your interest by providing evidence that the goods that you are buying have been shipped before payment is made.

Take The Next Necessary Steps

Now that you have taken a more thorough look into LOCs and approaches you can take to manage their risks, contact your bank to find out if they can help you. Elaborate what you need to grow your business. Discuss your needs with them to see what your best solutions are.

Once an approach is determined, take the next step and open an account with them. A good bank with great sets of open financing solutions can help you optimise your business’ working capital, reduce costs, and gain better control and visibility over your receivables.

Conclusion

While useful, LOCs come with a set of risks. However, with various solutions and approaches in the modern business banking world, these risks can be managed to ensure that your business will have sustainable growth while still being able to tap into the international market.

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