Finance & Credit

If You Think The Letter Of Credit Is Dead...Think Again, March 2004

March 1, 2004
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I remember being a young investor and hearing that the graveyards on Wall Street are filled with those that have been right too early. Well, I've been hearing the letter of credit (L/C) is a sunset product for what seems like decades, and many in the banking industry will retire on its use. It's easy and intuitive to believe the 'L/C is dead' theory.

Global Business Intelligence recently conducted detailed research on the international procurement initiatives of major importers in North America. Now, I consider myself to have a pretty good finger on the pulse of the industry, and even here I was surprised to find how embedded the L/C payment instrument still is. That's not saying that the desire to change is not there; it just hasn't happened yet.

L/Cs continue to be the dominant payment method for many major finished goods and retail importers. Why? We believe there are six primary reasons why importers have not moved to open account (OA) quicker:

  • Major importers don't pay transaction fees--their overseas vendors do! Treasury Departments benefit, while their counterparts in Purchasing may end up paying for the increased overhead.

  • Liquidity and vendor financing. Our research suggests that while vendor financing was a very distant secondary objective after other priorities in the purchase-to-pay cycle (i.e. the information flow, automation on the buyer side, etc.), it was the one thing holding back more of the larger vendors from moving to OA. Many Asian vendors still do Back to Backs, Transferables, and Packing loans (a form of transactional finance where their bank provides a percentage of the L/C value). This system has been in place for decade.

  • Compliance. Usually a key variable in maintaining L/C terms for importers is customs compliance and the number of vendor relationships to manage. Compliance is critical to these companies. The L/C is much broader than a payment method; it can help manage the process of bringing goods and clearing customs.

  • Vendor's loss of control through OA terms. This loss of control happens in two areas: 1) How disputes are managed. Vendors know that if they comply with the L/C, they get paid. Under OA trading, short pays can occur outside their control; 2) Compliance. The loci of examination move from the seller's bank to the buyer.

  • Internal systems. Controls, processes and systems must be put in place by the importer. This takes Information Technology resources and money, which are generally allocated to sales growth and merchandising initiatives.

  • Recognition that banks provide an outsourcing service for compliance checking. Many major importers expressed a desire to move to OA terms with more of their vendor base and are taking action to do so. Our point is that it's not happening overnight.

So why is the L/C being challenged now?

The chief reason is credit. Number 1, it's scarce, Number 2, banks continue to consolidate and an importer's debt group shrinks, and Number 3, with upcoming changes to banks' capital allocation methods, i.e., Basel II, riskier companies will pay more, etc. If you are a company that traditionally issues an L/C 60 to 90 days ahead of shipment, and then once shipment occurs, it takes another 2 to 3 weeks to release your line, or you just revolve the L/C with an amendment, you are tying a lot of capital up in the ordering process. That costs money and takes away liquidity from other projects.

Other reasons have to do with long-term relationships with suppliers, cash-rich Asian vendors that do not need L/Cs, companies pruning their supplier base to 'core' and non-core suppliers, and an increased emphasis on efficiency and automation, particularly more investment in supply chain collaborative efforts.

The banks' role

In the past few years, both banks and non-banks have been working to expand and develop new open account solutions for importers. A few industry trends are driving this. The first trend is that more companies are sourcing direct from overseas vendors. If you are in retail, the private label business has been growing. This had led to more direct imports. Look at GAP jeans and Levis, or Hilfilger perfume. If you are in consumer goods, you have been closing manufacturing assets here and abroad and moving to contract manufacturing and more direct imports.

The second trend is a desire by corporations to move away from credit intensive Letters of Credit as described above.

The third trend involves solving the 'Where are the goods?' and 'When will they get here?' problems. Unlike domestic trade, which is very much an EDI world of sending EDI Purchase Orders and receiving electronic ship notices (i.e., ASNs), and possibly even invoices via EDI--in the International world, once product is ordered, you have a number of points that can lead to timing problems.

Given these trends, we found distinct classes of importers, and for those not building proprietary supply chain business systems, the banks and vendors can play an active role in the financial value-added areas for international trade. While this is not always about a straight-through process, bringing products into the country can and does involve high-touch processes, and banks can help.

Some areas where banks are starting to play an active role are:

  • Purchase Order/Invoice Compliance verification before payment is made. This will range from simple and automated to manual, i.e., text-based compliance.

  • Vendor financing capabilities, particularly financing arrangements off of the Purchase Order using Vendor scorecard information (this is predicated on buyers willing to share this information).

  • Assist the vendor in the workflow around trade documentation. Once the vendor delivers the goods to the forwarder, the process of cargo receipts, inspection certificates, consular invoices, and other documentation begins. Having a workflow solution to facilitate the process would greatly aid buyers and sellers.

  • Reconciliation to back-end Accounts Payable and other systems. Retailers and consumer goods companies have L/C systems that are not always well integrated with ERP legacy payable systems. Providing assistance here, particularly as more and more importers develop supplier portals, will be important.

  • Document archives to deal with all the paper that is necessary for customs audits.

  • Bringing logistic and insurance parties into the fold to help where necessary.

Banks and vendors are approaching these new solutions, not just from an efficiency play, but also from one that can help importers with information about paying for goods and handling invoices and the status of the goods. Like any new solution, the start has been slow and frustrating as the market learns what works and what doesn't. There is not a 'one-size-fits-all slipper out there, and what's required is an understanding of major importers' cultures, business practices, vendor base, compliance and control issues and, perhaps most importantly, internal systems issues and logistics.

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