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Basics of Trade Services and Trade Finance January 1999

Global Corporate Bank Training and Development

Basics of Trade Services and Trade Finance

Warning This workbook is the product of, and copyrighted by, Citibank N.A. It is solely for the internal use of Citibank, N.A., and may not be used for any other purpose. It is unlawful to reproduce the contents of these materials, in whole or in part, by any method, printed, electronic, or otherwise; or to disseminate or sell the same without the prior written consent of Global Corporate Bank Training and Development – Latin America, Asia / Pacific and CEEMEA. Please sign your name in the space below.

Asia Pacific

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Table of Contents

TABLE OF CONTENTS

TABLE OF CONTENTS Introduction Overview...................................................................................................................ix Course Objectives.....................................................................................................ix The Workbook ......................................................................................................... x

Unit 1: The Trade Environment Introduction ............................................................................................................ 1-1 Unit Objectives....................................................................................................... 1-1 Overview................................................................................................................ 1-2 Political Issues............................................................................................ 1-2 Business Issues ......................................................................................... 1-3 Social Issues .............................................................................................. 1-3 Legal Issues ............................................................................................... 1-3 Factors That Restrict Global Trade ........................................................................ 1-3 Tariffs ......................................................................................................... 1-4 Nontariff Barriers ........................................................................................ 1-4 Quotas........................................................................................................ 1-5 Factors That Promote Global Trade....................................................................... 1-5 Trade Agreements...................................................................................... 1-6 European Community .................................................................... 1-6 North American Free Trade Agreement (NAFTA)........................... 1-8 MERCOSUR ................................................................................... 1-9 Pacto Andino (Andean Pact) ........................................................ 1-10 Trade Agreements / Organizations........................................................... 1-10 General Agreement on Tariffs and Trade (GATT) ........................ 1-11 Asociación Latino-Americana de Integración (ALADI) .................. 1-12 Export Credit and Multilateral Agencies.................................................... 1-12 Export Credit Agencies (ECAs)..................................................... 1-13 Multilateral Agencies..................................................................... 1-13 World Bank Group ............................................................... 1-14 World Bank Affiliates ............................................................ 1-15

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Unit 1: The Trade Environment (Continued) Overseas Private Investment Corporation (OPIC) ............... 1-15 Regional Development Banks.............................................. 1-16 Unit Summary ...................................................................................................... 1-17 Progress Check 1 ................................................................................................ 1-19

Unit 2: Trade Services Introduction ............................................................................................................ 2-1 Unit Objectives....................................................................................................... 2-1 Establishing Terms Between Buyers and Sellers................................................... 2-2 Payment Options ................................................................................................... 2-3 Cash in Advance ........................................................................................ 2-4 Open Account ............................................................................................ 2-6 On Consignment ........................................................................................ 2-9 Documentary Collections.......................................................................... 2-12 Advantages and Risks to the Buyer, Seller, and Citibank............. 2-15 Summary .................................................................................................. 2-18 Progress Check 2.1 ............................................................................................. 2-19 Letters of Credit (L/C) .......................................................................................... 2-31 Parties to a Letter of Credit ...................................................................... 2-31 Revocable or Irrevocable Letter of Credit................................................. 2-32 Basic Letter of Credit Components .......................................................... 2-32 Commercial and Standby Letters of Credit .......................................................... 2-33 Commercial Letters of Credit.................................................................... 2-34 Settlements Under a Letter of Credit ............................................ 2-36 Types of Irrevocable Commercial Letters of Credit ....................... 2-37 Special Features of Commercial Letters of Credit ........................ 2-39 Advantages and Risks of Commercial Letters of Credit................ 2-42 Import Letter of Credit and Export Letter of Credit........................ 2-46 Standby Letters of Credit ......................................................................... 2-47 Standby Letter of Credit: Guarantee Type................................... 2-48 Standby Letter of Credit: Payment Type...................................... 2-49 Advantages and Risks of Standby Letters of Credit ..................... 2-51 v-2.1

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Unit 2: Trade Services (Continued) Other Legal Forms of Guarantee ............................................................. 2-54 Summary .................................................................................................. 2-56 Progress Check 2.2 ............................................................................................. 2-59 Financial and Commercial Transaction Documents ............................................. 2-73 Financial Documents................................................................................ 2-73 Check ........................................................................................... 2-73 Draft / Bill of Exchange ................................................................. 2-73 Promissory Note ........................................................................... 2-74 Commercial Documents ........................................................................... 2-75 Commercial Invoice ...................................................................... 2-75 Bill of Lading ................................................................................. 2-75 Insurance Document / Policy ........................................................ 2-76 Other Documents.......................................................................... 2-77 Unit Summary ...................................................................................................... 2-78 Progress Check 2.3 ............................................................................................. 2-81

Unit 3: Trade Finance Introduction ............................................................................................................ 3-1 Unit Objectives....................................................................................................... 3-1 Extension of Credit ................................................................................................ 3-2 Establishing Creditworthiness .................................................................... 3-2 Identifying Risks ......................................................................................... 3-3 Setting Interest Rates................................................................................. 3-4 Establishing Credit Terms .......................................................................... 3-5 Determining the Type of Financing ............................................................ 3-6 Short Term Loan............................................................................. 3-7 Medium Term Loan......................................................................... 3-7 Line of Credit .................................................................................. 3-7 Syndication ..................................................................................... 3-8 Booking Transactions................................................................................. 3-8 Managing the Credit ................................................................................... 3-9 Purposes for Trade Financing................................................................................ 3-9

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Pre-Export Financing................................................................................ 3-11 Export Financing ...................................................................................... 3-13 Import Financing....................................................................................... 3-13 Inventory (Warehouse) Financing ............................................................ 3-13 Summary .................................................................................................. 3-14 Progress Check 3.1 ............................................................................................. 3-15 Types of Export Financing ................................................................................... 3-23 Commercial Financing.............................................................................. 3-23 Banker’s Acceptance .................................................................... 3-25 Application of Bankers’Acceptances ................................... 3-25 Pricing .................................................................................. 3-26 Eligible and Ineligible Banker’s Acceptance......................... 3-27 Risks .................................................................................... 3-28 Forfaiting....................................................................................... 3-29 Advantages of Forfaiting ...................................................... 3-34 Disadvantages of Forfaiting ................................................. 3-35 Required Documentation ..................................................... 3-35 Summary .................................................................................................. 3-36 Progress Check 3.2 ............................................................................................. 3-37 Types of Export Financing (Continued) ................................................................. 3-41 Export Credit Agency-Supported Financing ............................................. 3-41 ECA Guarantee and Insurance ............................................ 3-42 Cash Payment Requirement......................................................... 3-42 Sourcing from Multiple Countries .................................................. 3-42 Local Costs Financing .................................................................. 3-43 Funding Mechanisms.................................................................... 3-43 Interest Rates: Floating and Fixed ............................................... 3-44 Insurance Coverage ..................................................................... 3-46 Transaction Structures: Buyer Credit and Supplier Credit ............ 3-47 Buyer’s Credit Financing ...................................................... 3-47 Supplier’s Credit Financing .................................................. 3-48 Multilateral Agency (MLA)-Supported Financing........................... 3-50

Unit 3: Trade Finance (Continued) Private Insurance-Supported Financing ................................................... 3-51 v-2.1

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Export Finance: Structuring the Deal .................................................................. 3-52 Option One – Buyer’s Credit Combined with Insurance or ECA Guarantee ........................................................................ 3-54 Option Two – Forfait Market ......................................................... 3-54 Summary .................................................................................................. 3-55 Correspondent Banking ....................................................................................... 3-55 Relationship Among Banks ...................................................................... 3-56 Products ................................................................................................... 3-56 Letter of Credit Confirmation......................................................... 3-57 Nonsovereign Funding.................................................................. 3-57 Participations ................................................................................ 3-59 Unit Summary ...................................................................................................... 3-60 Progress Check 3.3 ............................................................................................. 3-63

Unit 4: Risk and Compliance Introduction ............................................................................................................ 4-1 Unit Objectives....................................................................................................... 4-1 Risks for the Bank.................................................................................................. 4-2 Credit Risk.................................................................................................. 4-3 Lending Risk ................................................................................... 4-3 Counterparty Risk ........................................................................... 4-3 Country (Political and Cross-Border) Risk .................................................. 4-4 Political (Sovereign) Risk ................................................................ 4-5 Transfer Risk .................................................................................. 4-5 Convertibility Risk ........................................................................... 4-6 Other Risks................................................................................................. 4-7 Image Risk...................................................................................... 4-7 Product Risk ................................................................................... 4-7 Operational / Systems Risk............................................................. 4-8 Legal and Regulatory Risk.............................................................. 4-8 Documentation Risk........................................................................ 4-8

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Risks in a Trade Finance Transaction ........................................................ 4-9 Risk Management ................................................................................................ 4-10 Allocating Cross-Border Risk.................................................................... 4-10 Risk Transfer ....................................................................................................... 4-12 Risk Transfer Through Syndication .......................................................... 4-12 Investors in Risk Transfer Transactions ................................................... 4-14 Banks............................................................................................ 4-14 Insurance Companies ................................................................... 4-14 Export Credit Agencies (ECAs)..................................................... 4-16 Other Investors – Forfaiting .......................................................... 4-17 Example of Risk Transfer / Risk Management.............................. 4-18 Option One........................................................................... 4-19 Option Two........................................................................... 4-19 Option Three ........................................................................ 4-20 Advantages of Risk Transfer .................................................................... 4-20 Summary ............................................................................................................. 4-21 Progress Check 4.1 ............................................................................................. 4-23 Compliance Issues............................................................................................... 4-33 US Sanctions ........................................................................................... 4-34 Sanction Administration in the US ................................................ 4-35 Reporting Requirements ............................................................... 4-36 Penalties....................................................................................... 4-36 US Anti-Boycott Laws and Regulations.................................................... 4-36 Reporting Requirements ............................................................... 4-37 Penalties....................................................................................... 4-37 Discovering Noncompliance Issues .............................................. 4-38 US Export Controls................................................................................... 4-39 Reporting Requirements ............................................................... 4-40 Penalties....................................................................................... 4-40 Anti-Money Laundering ............................................................................ 4-41 The Money Laundering Process ................................................... 4-41

Unit 4: Risk and Compliance (Continued) Reporting Requirements ............................................................... 4-41 v-2.1

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Avoiding Problems........................................................................ 4-42 Unit Summary ...................................................................................................... 4-43 Progress Check 4.2 ............................................................................................. 4-45

Unit 5: Identifying Customers’Needs and Pricing Solutions Introduction ............................................................................................................ 5-1 Unit Objectives....................................................................................................... 5-1 The Information Gathering Process ....................................................................... 5-2 Existing Customers .................................................................................... 5-2 New Customers.......................................................................................... 5-3 Key Pricing Benchmarks........................................................................................ 5-9 Minimum Return on Cross-Border Risk ...................................................... 5-9 Expected Return on Assets...................................................................... 5-10 Revenue-to-Expense Ratio ...................................................................... 5-11 Market Quotations for Similar Risks ......................................................... 5-11 Pricing Guidelines ................................................................................................ 5-12 Risk Identification ..................................................................................... 5-12 General Guidelines................................................................................... 5-13 Documentary Collections, Transfers, and Payment Orders .......... 5-13 Import Letters of Credit ................................................................. 5-14 Export Letters of Credit................................................................. 5-15 Trade Finance............................................................................... 5-16 Selling Trade Paper ...................................................................... 5-18 Presenting the Offer to the Customer .................................................................. 5-19 Unit Summary ...................................................................................................... 5-25 Progress Check 5 ................................................................................................ 5-27

Appendices Appendix A — Glossary......................................................................................A-1 Appendix B – Index.............................................................................................B-1

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INTRODUCTION


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INTRODUCTION

OVERVIEW “Trade” is the movement of goods and services that develops from a business transaction between a buyer and a seller. Facilitating trade is one of the most important activities in a bank. Because of the large number of legal, political, and business issues and risks involved in any trade transaction, Citibank has developed many different products to accommodate its customers’ trade needs. This workbook is designed as an introduction to Citibank trade services and finance. In the following pages we examine the global trade environment, discuss the trade services and products that are available to Bank customers, and analyze the risks and benefits of these products and services to the Bank. We then identify several compliance issues that are essential to the safe and effective provision of trade services, and outline the process of pricing customer solutions.

COURSE OBJECTIVES When you complete this workbook, you will be able to: • Understand the global trade environment • Recognize trade agreements, organizations, and other factors that facilitate / restrict global trade • Recognize the documents required for trade transactions • Identify Citibank trade products and services • Understand the role of correspondent banks and export credit agencies in providing trade products and services • Identify the risks involved in trade transactions and understand how Citibank transfers risk

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• Recognize trade compliance issues and key regulations / legislation • List and describe factors for analyzing customer needs and trade opportunities

THE WORKBOOK This workbook is designed to give you complete control over your own learning. The material is divided into workable sections, each containing everything you need to master the content. You can move through the workbook at your own pace and go back to review ideas that you didn’t completely understand the first time. Each unit contains:

þ

Objectives –

which point out important elements in the lesson that you are expected to learn.

Text –

which is the “heart” of the workbook. This section explains the content in detail.

Key Terms –

which also appear in the Glossary. They appear in bold face the first time they appear in the text.

Instructional Mapping –

terms or phrases in the left margin which highlight significant points in the lesson.

Progress Checks –

which do exactly what they say — check your progress. Appropriate questions are presented at the end of each unit, or within the unit in some cases. You will not be graded on these by anyone else; they are to help you evaluate your progress. Each set of questions is followed by an Answer Key. If you have an incorrect answer, we encourage you to review the corresponding text and find out why you made an error.

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In addition to these unit elements, the workbook includes: Appendix A, Glossary –

Which contains definitions of all key terms used in the workbook.

Appendix B, Index –

Which helps you locate glossary items in the workbook.

Each unit covers an aspect of trade services and trade finance. The units are: UNIT 1 – The Trade Environment UNIT 2 – Trade Services UNIT 3 – Trade Finance UNIT 4 – Risk and Compliance UNIT 5 – Identifying Customers’ Needs and Pricing Solutions

Since this is a self-instructional course, your progress will not be supervised. We expect you to complete the course to the best of your ability and at your own speed. Now that you know what to expect, please begin with Unit 1. Good luck!

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INTRODUCTION


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Unit 1


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UNIT 1: THE TRADE ENVIRONMENT

INTRODUCTION At Citibank, we strive to be the most competent, profitable, and innovative financial service organization in the world. To accomplish this goal, we must continually assess the environment in which we operate, offer trade solutions that best meet our customers’ needs, and measure the risks associated with conducting business. We begin this unit by examining the global trade environment and the factors that enable or restrict the flow of goods and services. We then describe the European Community and discuss three agreements that affect trade in the Latin American region as well as two multinational agreements / organizations that promote trade. A description of the export credit agencies in several countries and the multilateral agencies that facilitate international commerce completes our study of the trade environment.

UNIT OBJECTIVES When you complete Unit 1, you will be able to: n

Recognize issues and identify factors that restrict / promote global trade

n

Recognize trade agreements in Latin America and Europe that promote regional trade

n

Recognize two multinational organizations that promote international trade

n

Identify government support programs for national exports

n

Distinguish between export credit agencies and multilateral agencies

n

Recognize the role of the World Bank, its affiliates, and regional development banks in promoting international trade

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THE TRADE ENVIRONMENT

OVERVIEW In the past, trade was conducted directly between countries. Today, countries have grouped themselves into trading blocks to: n

Reinforce their individual strengths

n

Strengthen their positions in the trade environment

Each block of countries has its own set of rules and regulations for domestic, intrablock, and global trade. To support the global interests of their customers, banks either have a multiblock presence or they have special arrangements with other banks operating in a region. These special arrangements, called correspondent relationships, are discussed in Unit 3. Factors restrict or promote flow of goods

Political, business, social, and legal issues affect the global trade environment. As trade officers, we need to carefully analyze all aspects of the environments in which our customers conduct their business.

Political Issues Political issues (e.g. civil wars, riots, political unrest, and revolutions) occur in all parts of the world and affect global trade. For example, many political changes are taking place in China today. We must monitor China’s adherence to the International Chamber of Commerce (ICC) rules in order to act as trade advisors to our customers.

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1-3

Business Issues Basic differences in the business philosophies of eastern and western countries also must be considered. In western countries, companies tend to focus on shareholders first and then on customers and employees. In eastern countries, these priorities are usually reversed – the customer and his/ her needs are most important.

Social Issues When conducting business in the world marketplace, we must acknowledge cultural traditions, social welfare, social behaviors, and the influence of religion on consumption behavior.

Legal Issues Legal issues that affect business include licensing arrangements, ownership questions, and local laws. Other legal concerns are tariffs and quotas. As we mentioned earlier, political, business, social, and legal issues affect the global trade environment. Factors related to these issues may restrict or promote global trade. Let’s first examine those factors that limit global trade.

FACTORS THAT RESTRICT GLOBAL TRADE Most countries appear to conform to international principles of free trade. However, some countries impose trade-restricting measures such as tariffs, nontariff barriers, and quotas on trading partners.

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Tariffs Taxes on imported goods

Example

Tariffs are taxes that are placed on imported goods to: n

Protect domestic businesses from foreign competition

n

Discriminate, if they apply unequally to products of different countries

n

Retaliate, if they are designed to compel another country to remove artificial trade barriers

The tariff imposed on Japanese motorcycles is an example of a protective tariff. In 1983, Harley-Davidson, a US manufacturer, was having difficulty competing with the heavyweight bikes imported from Japan by Honda and Kawasaki. The US Government imposed a five-year tariff on Japanese bikes imported into the United States. This gave Harley-Davidson management time to reorganize the company and become competitive again — without pressure from the Japanese imports. By 1987, Harley-Davidson had regained its share of the market in the heavyweight class of bikes and requested that the tariff be lifted a year early. Nontariff Barriers

Importrestricting measures

Nontariff barriers consist of a variety of measures that restrict imports. These measures include testing, certification, or bureaucratic hurdles.

Example

An interesting example of bureaucratic hurdles occurred in France in 1983. The French government decided to reduce the importation of foreign video recorders and mandated that all recorders had to be sent to the customs station at Poitiers — which was far from the normal transportation routes. Because the station was understaffed, operated only a few days per week, and each individual package had to be opened, the import of video recorders was effectively stopped. Meanwhile, the French were able to assert their adherence to international agreements.

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Quotas Restrictions on quantity of imports and exports

Quotas are restrictions on the quantity of specific products that can be imported and exported. Sometimes import quotas are imposed to prevent damage to a domestic industry, e.g. clothing and textiles. Occasionally, this action has unexpected results.

Example

For example, in the early 1970s, quotas placed on tuna fish packed in oil from Japan prevented the tuna from entering the US market. This forced the Japanese to concentrate on packing tuna in water even though, at that time, only 7% of tuna was packed in water. The Japanese became quite successful and created a niche for themselves in the tuna-packed-in-water market. Export quotas are set for reasons of national defense, economic stability, and price support. For example, it is United States government policy to control the export of weapons and high technology that may have an adverse effect on national security. Tariffs, nontariff barriers, and import and export quotas all function to restrict or limit foreign trade. There also are several methods that serve to promote global trade.

FACTORS THAT PROMOTE GLOBAL TRADE The current trend in international trade is to open markets that traditionally have been protected with restrictive factors such as quotas and tariffs. In this section, we describe:

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n

Trade agreements that were created to encourage international trade (European Community, NAFTA, MERCOSUR, and Pacto Andino)

n

Trade agreements / organizations (GATT and ALADI) that Latin American countries have joined to strengthen their commitment to global trading

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n

Government and multilateral agencies (MLAs), through which governments provide financial assistance to support world trade (export credit agencies [ECAs], World Bank, and regional development banks)

Trade Agreements A trade agreement is an agreement between two or more countries concerning the buying and selling of each country’s goods and services. Countries enter into trade agreements to facilitate trade among the member countries. Their objectives are to: n

Diversify export markets

n

Create or explore trade opportunities without barriers

n

Protect products from other markets

n

Encourage economic development of the region

While there are many trade agreements in different parts of the world, one plays a major role in Europe (the European Community [EC]), and three of them directly influence trade in Latin America: North American Free Trade Agreement (NAFTA), MERCOSUR, and Pacto Andino. European Community The European Community (EC) is a group of European countries that have joined together to establish a common market which assures the free movement of people, goods, services, and capital.

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Member States

As of 1995, the EC consisted of the following 15 member states (countries): Austria, Belgium, Denmark, Finland, Germany, Greece, France, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, Sweden, and United Kingdom. Other countries are being considered for membership.

European Community vs. Free-trade Zone

The European Community has established a customs union consisting of a common customs tariff and a customs code. It also has at its disposal commercial policy instruments for ensuring that its products and services have access to third-country markets. The EC uses instruments to ensure equal competition between itself and third countries on the basis of anti-dumping and anti-subsidy laws. The EC is different from a free-trade zone. The EC has a common customs tariff and a customs code. On the other hand, in a free-trade zone, each member country: n

Retains its own customs tariff and customs code

n

Decides its national trading policy quite independently

A free-trade zone does not constitute a uniform trading bloc with third countries. The European Community is the largest trading power in the world – even larger than the United States or Japan. While all three have large domestic markets, they are not growing as rapidly as other international markets and, as a result, the competition among the three is intense for other international markets.

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North American Free Trade Agreement (NAFTA) Canada, the United States, and Mexico

In 1994, the North American Free Trade Agreement became effective to facilitate the flow of goods and capital between Canada, the United States, and Mexico. These countries have agreed to establish a free trade zone among their territories and to consider products, services, and capital from any of the three countries as if they were their own. NAFTA represents the largest world market with 370 million consumers. Its main objectives are to: n

Eliminate trade barriers and facilitate the cross-border flow of goods and services among the parties

n

Promote fair conditions for competition within the free trade zone

n

Significantly increase investment opportunities

n

Provide adequate protection to patent holders, copyrights, and transfers of technology — and to guarantee that all intellectual property can be traded safely

n

Create effective procedures for the implementation of this treaty, its joint administration, and resolution for disputes

n

Establish parameters and guidelines for future regional and multilateral (involving more than two countries or parties) cooperation to improve and expand the benefits of NAFTA

The last objective is especially important because NAFTA is designed for the eventual participation of other countries. Chile, for example, is interested in joining in the near future. In addition, Canada has expressed an interest in inviting non-Latin American countries such as Australia and other Pacific Rim countries.

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MERCOSUR Argentina, Brazil, Paraguay, and Uruguay

The Southern Cone Common Market (MERCOSUR) is an agreement between Argentina, Brazil, Paraguay, and Uruguay to create a common market for the member countries. The agreement, which became fully operational on January 1, 1995, has the following objectives: n

Establish the free movement of capital, goods, services, and people

n

Create a common trade tariff structure and establish a common policy

n

Coordinate macroeconomic policies

MERCOSUR establishes an automatic progressive tariff schedule

to phase out existing tariffs in a period of three to four years and to remove restrictions on the movement of labor, goods, and services. The consumer and productivity potential for member countries is significant. MERCOSUR is modeled after the European Community (EC) and, if successful, will encompass a geographical area that is twice the size of the EC. Chile became an associate MERCOSUR member in early 1996. Peru, Ecuador, Venezuela, Colombia, and Bolivia have agreed to start talks to link the Pacto Andino with MERCOSUR.

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Pacto Andino (Andean Pact) Peru, Ecuador, Colombia, Chile, Bolivia, and Venezuela

The third agreement that influences Latin American trade is the Pacto Andino (Andean Pact). Peru, Ecuador, Colombia, Chile, Bolivia, and Venezuela entered into this agreement to form a Latin American common market. These countries agreed to create common rules for foreign investment and an eventual common external tariff. Unfortunately, the Andean Pact has not had much success in achieving its goals. During the seventies and eighties, the Latin American countries were affected by the external debt crisis and forced to concentrate on their individual problems rather than on regional matters. Several Andean countries are trying to revive the arrangement to serve broader regional trading objectives. In 1993, Venezuela, Colombia, and Peru adopted a uniform tariff. The objectives of the Andean Pact are to: n

Promote peaceful and equal development among its members

n

Encourage an acceleration of growth through economic integration

The emphasis on opening new markets brings renewed hope for growth in the global trade environment. We now look at two multinational organizations which enhance global competition. Trade Agreements / Organizations Two multinational trade agreements / organizations that promote international trade are General Agreement on Tariffs and Trade (GATT) and Asociación Latino-Americana de Integración (ALADI). They encourage orderly international financial conditions and provide advice on capital and economic development.

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General Agreement on Tariffs and Trade (GATT) Abolishes quotas and reduces tariffs

The General Agreement on Tariffs and Trade (GATT) is an organization with a set of trade agreements created to abolish quotas and reduce tariffs among participating nations. It was originally created in 1947 as a temporary arrangement, pending its replacement by a UN agency. The UN agency was never established, and GATT was expanded at several succeeding negotiations. It has proven to be one of the most effective instruments for world trade liberalization. At its international headquarters in Geneva, GATT has a secretariat, a Council of Representatives, an annual assembly called the Sessions, and an International Trade Center. With over 100 member countries, GATT affects almost 90% of world trade. The provisions of GATT include:

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n

A schedule of tariff concessions for each participating nation

n

Unconditional most-favored-nation clauses that guarantee other GATT countries the extension of any tariff concessions that have been granted to non-GATT countries

n

Elimination of quotas and other trade restrictions

n

Uniform custom regulations and the obligation of each contracting nation to negotiate for tariff cuts upon the request of another member nation

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Asociación Latino-Americana de Integración (ALADI) The Asociación Latino-Americana de Integración (ALADI) is an organization established by the Treaty of Montevideo in 1980. It began as an agreement signed in 1965 under the Asociación LatinoAmericana de Libre Comercio (ALALC). Member countries include Argentina, Brazil, Mexico, Chile, Colombia, Peru, Uruguay, Venezuela, Bolivia, Ecuador, and Paraguay. Promotes financial relationships among private banking agencies

ALADI’s purpose is to promote financial relationships among

private banking agencies. It provides its members with a mechanism for financing for Latin American intraregional trade. ALADI allows for central bank payment guarantees of short and medium-term trade credits among banks of member customers. ALADI is a clearing system between the Central Banks of the

member countries. Clearing occurs three times a year and settles all import and export transactions under the ALADI agreement between member countries. The settlement between the Central Banks is in US dollars only. ALADI’s Council of Ministers is comprised of the foreign ministers

of the member countries. The Conference of Contracting Parties makes decisions on questions requiring a resolution of the members. The Secretariat performs technical and administrative duties.

Export Credit and Multilateral Agencies Direct and indirect government involvement

Commercial banks are not the only entities involved in financing world trade and economic development. Governments participate in these activities, both directly through their own national organizations (export credit agencies) and indirectly through their membership in a variety of international economic organizations (multilateral agencies).

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Export Credit Agencies (ECAs) Support and expand local exports

Export Credit Agencies are national organizations that support and expand local exports to benefit the country’s balance of payments and, as a result, create jobs in the local market. The ECA programs enable the Bank’s customers (exporters) to remain competitive with businesses from other countries. Importers also benefit from access to preferential rates and terms for loans from programs of the exporting countries.

ECA programs

ECA assistance is provided in the form of guarantees or insurance as well as direct lending. ECA programs include: n

Insurance to national exporters and commercial banks against commercial (credit) and/or country risks

n

Payment guarantees to commercial banks involved in export financing

n

Preferential fixed interest rate loans to foreign importers

In Unit 3 we provide additional details on the different characteristics of the ECAs. Multilateral Agencies Governments working together have established institutions whose purpose is to maintain orderly international financial conditions and to provide capital and advice for economic development, particularly in those countries that lack the resources to do it themselves. These institutions or multilateral agencies play an increasing role in the financing of large export contracts and projects. We discuss first the globally-oriented World Bank, its entities and affiliates, and then examine the role of regional development banks.

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World Bank Group

The World Bank Group is comprised of the International Bank for Reconstruction and Development(IBRD) and the International Development Association (IDA) and two affiliates, the International Finance Corporation (IFC) and the Multilateral Investment Guarantee Agency (MIGA). Let’s examine their specific roles. World Bank

The World Bank is a multilateral development agency. Its purpose is to help member countries progress economically and socially so that their people may live better and fuller lives. The World Bank is the primary source of funding for projects in emerging-market countries when private capital cannot be raised. In addition to lending medium and long-term funds directly to governments in the emerging markets, the World Bank provides technical and financial aid to private-sector companies for direct investments.

World Bank entities: IBRD and IDA

The term “World Bank” refers to two legally and financially distinct entities: the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA). The IBRD and IDA have three related functions: •

Lend funds

•

Provide economic advice and technical assistance

•

Serve as a catalyst to investment by others

Both the IBRD and the IDA provide training and technical advice to help developing countries address their own problems. However, the IBRD makes market-rate loans to newly industrialized countries (e.g. Korea, Brazil) by borrowing in the world capital markets. The IDA extends assistance to the poorest countries on easier terms (e.g., interest-free loans), largely from resources provided by its wealthier members.

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Funds from such other sources as governments, commercial banks, export credit agencies, and other multilateral institutions are increasingly being paired with World Bank funds to cofinance projects. World Bank Affiliates IFC and MIGA

The International Finance Corporation (IFC), an affiliate of the World Bank, is the world’s largest multilateral organization specifically structured to provide loans to — and equity investments in — private companies in the emerging markets. It seeks to promote growth in the private sector of the emerging market countries by mobilizing foreign and domestic capital to invest alongside its own funds in commercial enterprises. The Multilateral Investment Guarantee Agency (MIGA), also an affiliate, encourages foreign direct investment in emerging markets countries by providing: •

Investment guarantees against the risks of currency transfer, expropriation, war and civil disturbance, and breach of contract by the host government

•

Advisory services to MIGA’s member countries on means of attracting foreign investment

Overseas Private Investment Corporation (OPIC)

The Overseas Private Investment Corporation (OPIC) is a profit-making US government agency. Its primary objective is to insure or guarantee US investment in more than 130 developing countries throughout the world. It also offers some export finance assistance. OPIC’s programs provide: •

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Project financing through direct loans and loan guarantees

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•

Investment insurance, including coverage for medium and long term loans from Citibank NY to its branches and subsidiaries, against a broad range of country risks

•

A variety of investor services (e.g. advisory services, country and regional information)

OPIC’s insurance program protects investors and commercial

bank lenders against the risk of inconvertibility of a currency, loss of investment due to expropriation, nationalization, or confiscation by action of a foreign government or loss due to political upheavals such as revolution or civil war. OPIC’s insurance program does not protect commercial bank lenders or investors from the commercial risk, i.e. credit and foreign exchange risk.

Regional Development Banks

Regional development banks provide funding for building infrastructures and private businesses in emerging markets countries. Even if a project does not meet the necessary criteria for financing from the development bank, assistance is still available to help companies locate direct investment financing from other sources. The most important regional development banks are owned by the governments of many donor countries, both from the industrialized world and from emerging markets, and serve mainly as central banks for local development banks. They also offer direct financing to private sector-businesses. The most important development banks are: •

The Inter-American Development Bank (for Latin America)

•

The Asian Development Bank (for Asia and the Pacific)

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•

The African Development Bank and Fund (for Africa)

•

The European Bank for Reconstruction and Development (for Eastern Europe and the Commonwealth of Independent States)

•

The European Investment Bank (for the funding of worldwide interests of the European Union)

•

Corporacion Andina de Fomento (for Pacto Andino countries)

UNIT SUMMARY In this unit, we examined some political, business, social, and legal conditions that promote or restrict global trade. We considered the factors that limit global trade — tariffs, nontariff barriers, and quotas. We introduced the trade agreement that plays a major role in Europe and the three agreements that encourage trade in the Latin American region, as well as two multinational organizations created to help countries compete in the world marketplace. We described governments’ direct and indirect contributions to the promotion of international trade. Export credit agencies in the US and other countries are established by national governments to support exports and improve the country’s balance of payments. Multilateral agencies, such as the World Bank and regional development banks, seek to maintain orderly international financial conditions and provide capital and advice for economic development. You have completed Unit 1, The Trade Environment. Please complete the Progress Check to test your understanding of the concepts and check your answers with the Answer Key. If you answer any questions incorrectly, please reread the corresponding text to clarify your understanding. Then, continue to Unit 2, Trade Services.

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PROGRESS CHECK 1

Directions: Determine the one correct answer to each question unless directed otherwise. Check your answers with the Answer Key on the next page.

Question 1: Determine how the following factors affect the trade environment. Place a P for those that promote trade and an R for those that restrict trade. _____ Civil unrest in the country where the goods are being exported _____ A country importing goods is a member of GATT _____ A quota has been placed on imports of leather shoes _____ An export credit agency will provide preferential financing rates to foreigners who buy that country’s exports _____ A multilateral agency guarantees repayment of a Citibank loan to a customer from an emerging-market country who is purchasing computers from a US firm _____ A new trade agreement establishes a free trade zone in participating countries _____ To protect its own bicycle market, a country places a tariff on imported bicycles _____ An importer in an emerging-market country receives low-cost financing from a World Bank entity.

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ANSWER KEY

Question 1: Determine how the following factors affect the trade environment. Place a P for those that promote trade and an R for those that restrict trade. R

Civil unrest in the country where the goods are being exported

P

A country importing goods is a member of GATT

R

A quota has been placed on imports of leather shoes

P

An export credit agency will provide preferential financing rates to foreigners who buy that country’s exports

P

A multilateral agency guarantees repayment of a Citibank loan to a customer from an emerging-market country who is purchasing computers from a US firm

P

A new trade agreement establishes a free trade zone in participating countries

R

To protect its own bicycle market, a country places a tariff on imported bicycles

P

An importer in an emerging-market country receives low-cost financing from a World Bank entity

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PROGRESS CHECK 1 (Continued)

Question 2: Which agreement establishes a free trade zone in Canada, the United States, and Mexico? _____ a) Pacto Andino _____ b) ALADI _____ c) MERCOSUR _____ d) NAFTA Question 3: A small country in Latin America requires the inspection of imported toasters. The inspector’s office is open one day a week and is understaffed. This is an example of a(n): _____a) nontariff barrier. _____b) import quota. _____c) tariff. _____d) export quota. Question 4: One of the reasons tariffs are placed on imported goods is to: _____ a) promote competition between domestic and foreign goods. _____ b) encourage foreign trade. _____ c) control imports. _____ d) create a favorable trade climate. Question 5: The trade agreement which creates a common market for Argentina, Brazil, Paraguay, and Uruguay is: _____a) MERCOSUR. _____b) Pacto Andino. _____c) ALADI. _____d) HERMES.

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ANSWER KEY

Question 2: Which agreement establishes a free trade zone in Canada, the United States, and Mexico? d) NAFTA Question 3: A small country in Latin America requires the inspection of imported toasters. The inspector’s office is open one day a week and is understaffed. This is an example of a(n): a) nontariff barrier. Question 4: One of the reasons tariffs are placed on imported goods is to: c) control imports. Question 5: The trade agreement which creates a common market for Argentina, Brazil, Paraguay, and Uruguay is: a) Mercosur.

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Question 6: Which multinational agreement / organization has over 100 member countries that account for almost 90% of world trade? _____ a) ALADI _____ b) NAFTA _____ c) Pacto Andino _____ d) GATT

Question 7: Which multinational agreement / organization provides a mechanism for financing to its members for Latin American intraregional trade? _____ a) ALADI _____ b) NAFTA _____ c) Pacto Andino _____ d) GATT

Question 8: Which trade agreement has created the largest trading power in the world? _____ a) NAFTA _____ b) GATT _____ c) ALADI _____ d) MERCOSUR _____ e) Pacto Andino _____ f) European Community

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ANSWER KEY

Question 6: Which multinational agreement / organization has over 100 member countries that account for almost 90% of world trade? d) GATT Question 7: Which multinational agreement / organization provides a mechanism for financing to its members for Latin American intraregional trade? a) ALADI Question 8: Which trade agreement has created the largest trading power in the world? f) European Community

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Question 9: Export credit agencies (ECAs) are established by: _____ a) commercial banks. _____ b) free trade agreements. _____ c) governments. _____ d) multilateral agencies.

Question 10: Identify two banks that are World Bank entities. _____ a) International Bank for Reconstruction and Development _____ b) African Development Bank and Fund _____ c) Inter-American Development Bank _____ d) International Development Association

Question 11: The trade agreement that has had the least amount of success in achieving its goals, primarily due to an external debt crisis in the seventies and eighties is: _____ a) ALADI. _____ b) Pacto Andino. _____ c) GATT. _____ d) MERCOSUR.

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ANSWER KEY

Question 9: Export credit agencies (ECAs) are established by: c) governments. Question 10: Identify two banks that are World Bank entities. a) International Bank for Reconstruction and Development d) International Development Association Question 11: The trade agreement that has had the least amount of success in achieving its goals, primarily due to an external debt crisis in the seventies and eighties is: b) Pacto Andino.

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Question 12: A small Guatemalan company is seeking financing to build a plant and purchase US equipment in order to export textile to the US. The two agencies most likely to assist with financing are: _____ a) ECA. _____ b) OPIC. _____ c) MIGA. _____ d) IFC.

Question 13: Select the statement that best describes the difference between an export credit agency (ECA) and a multilateral agency. _____ a) An ECA is an international organization that provides information to local exporters and their importers. Multilateral agencies provide funding to promote trade between emerging market countries. _____ b) ECAs within countries support the expansion of local exports. Multilateral agencies provide informational and financial assistance to support export activities in countries that lack the resources to do it themselves. _____ c) An ECA is a local agency affiliated with the Bank to assist customers in broadening their foreign markets. Multilateral agencies are international insurance agencies that provide capital to emerging market countries that compete for large export contracts. _____ d) Multilateral agencies provide funding to local companies that are just beginning to expand into foreign markets. ECAs provide low-cost, variable rate financing to foreign importers.

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ANSWER KEY

Question 12: A small Guatemalan company is seeking financing to build a plant and purchase US equipment in order to export textile to the US. The two agencies most likely to assist with financing are: a) ECA. (to finance the purchase of US equipment) d) IFC. (to finance the construction of the plant) Question 13: Select the statement that best describes the difference between an export credit agency (ECA) and a multilateral agency. b) ECAs within countries support the expansion of local exports. Multilateral agencies provide informational and financial assistance to support export activities in countries that lack the resources to do it themselves.

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Question 14: In emerging market countries, when private capital cannot be raised for large infrastructure improvement projects, governments may obtain marketrate funding from the: _____ a) local export credit agency. _____ b) World Bank Group’s International Development Association. _____ c) World Bank Group’s International Bank for Reconstruction and Development. _____ d) Overseas Private Investment Corporation.

Question 15: Match each of the following organizations with its role in promoting international trade. _____ International Finance Corporation (IFC) _____ Multilateral Investment Guarantee Agency (MIGA) _____ Overseas Private Investment Corporation (OPIC) _____ Regional development banks 1. Affiliate of the World Bank that provides investment guarantees against country risks and advice to member countries on how to attract foreign investment 2. Provides funding or assistance in locating funding for building infrastructures and private businesses in emerging market countries 3. Affiliate of the World Bank that promotes private sector growth in emerging market countries through direct investing and attracting foreign and domestic investors 4. US government agency with the primary objective of protecting US investments in developing countries against country risk

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ANSWER KEY

Question 14: In emerging market countries, when private capital cannot be raised for large infrastructure improvement projects, governments may obtain marketrate funding from the: c) World Bank Group’s International Bank for Reconstruction and Development. Question 15: Match each of the following organizations with its role in promoting international trade. 3

International Finance Corporation (IFC)

1

Multilateral Investment Guarantee Agency (MIGA)

4


2

Regional development banks

1. Affiliate of the World Bank that provides investment guarantees against country risks and advice to member countries on how to attract foreign investment 2. Provides funding or assistance in locating funding for building infrastructures and private businesses in emerging market countries 3. Affiliate of the World Bank that promotes private sector growth in emerging market countries through direct investing and attracting foreign and domestic investors 4. US government agency with the primary objective of protecting US investments in developing countries against country risk

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Question 16: Quotas are an example of ___________ issues which affect the global trade environment. _____ a) political _____ b) business _____ c) social _____ d) legal

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ANSWER KEY

Question 16: Quotas are an example of ___________ issues which affect the global trade environment. d) legal

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Unit 2


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UNIT 2: TRADE SERVICES

INTRODUCTION In an international trade transaction involving goods or services, the buyer and the seller negotiate details about the method and timing of both payments and delivery. These negotiations require attention to complex details concerning credit arrangements, transaction structuring, legal issues, and political and cross-border risks. Citibank customers, whether buyers and/or sellers, involved in an international trade transaction rely on the expertise of a global bank like Citibank for advice and assistance regarding these complex details. In the first two parts of this unit, you will learn about international payment options and how Citibank and Citibank customers use trade services to reduce the risks associated with trade transactions. In the third part, you will learn about the financial and commercial documents that facilitate international trade.

UNIT OBJECTIVES When you complete Unit 2, you will be able to: n

Identify the effect of leverage in a trade transaction

n

Identify five payment options for settling trade transactions

n

Recognize the risks and advantages of the five payment options to buyers and sellers, as well as the role and risks for Citibank

n

Distinguish between the two major categories of letters of credit – commercial letters of credit and standby letters of credit

n

Understand the application of different types of letters of credit to international trade transactions

n

Recognize the commercial and financial documents needed for a typical international trade transaction

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TRADE SERVICES

ESTABLISHING TERMS BETWEEN BUYERS AND SELLERS

Whenever goods are bought and sold, the buyer (importer) and the seller (exporter) conduct negotiations to determine the terms of the transaction. The terms of the transaction establish how much, when, and in what form the buyer will pay the seller. Buyer’s goals

The buyer’s goals during the negotiations are to: n

n

Minimize the total cost of the goods which, in addition to the agreed-upon price, may include: •

Cost of financing the goods between the time they are purchased and the time they are converted into cash upon subsequent resale

•

Lost opportunity cost of not being able to invest funds in the event available cash is used to pay for the goods

•

Foreign exchange costs if the deal is denominated in a currency other than the buyer’s

Maintain good relationships with sellers Poor payment practices may offend suppliers of materials that are critical to the production of the buyer’s goods. Conversely, the relationship with a seller who offers lenient payment terms is a valuable resource that the buyer will want to protect.

n

Seller’s goals

Assure receipt of specified goods previously contracted with the seller

The seller’s goals are to establish terms that: n

Increase the attractiveness of the product. By offering lenient trade terms to the buyer, it increases the likelihood that the buyer can afford the product.

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TRADE SERVICES

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n

Maximize the price of the goods without losing the sale Either through borrowing or through available cash, the seller must cover the cost between the time the sale is contracted and the final payment is received. The seller may try to build this cost into the price of the product, but runs the risk of making the goods less attractive.

n

Leverage

Assure payment from the buyer. The seller will examine all the risks associated with the trade transaction to ensure that — •

The buyer is able to pay

•

Funds can be converted to the currency of the seller’s country

•

Funds can be transferred to the seller’s country

The party with the most business influence during the negotiations will be more successful in dictating terms that meet the desired objectives. In other words, the amount of leverage each party has determines how many goals the seller and buyer will achieve. For example, a buyer who regularly purchases 90% of a seller’s product may be able to negotiate very favorable payment terms with that seller.

PAYMENT OPTIONS After establishing the terms of the deal, the two parties draw up a contract and the buyer issues a purchase order. The buyer and seller arrange one of five major payment options to settle the transaction:

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n

Cash in advance

n

Open account

n

On consignment

n

Documentary collections

n

Letters of credit

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TRADE SERVICES

In the next two sections, “Cash in Advance” and “Open Account,” we examine the distinct characteristics of these payment options and discuss their advantages and risks to the buyer and seller, as well as the role and risks for Citibank.

Cash in Advance Payment before shipment

Cash in advance is the most basic payment method for goods. The seller receives cash from the buyer before goods are shipped.

Buyer’s advantages and risks

There are no advantages to the buyer in this transaction and there are several risks to consider. For instance: n

Lack of control over the goods

n

Loss of the use of the funds paid to the seller

n

Refusal or inability of the seller to ship the goods

n

Political (sovereign) risk in the seller’s country until the goods are shipped. Political (sovereign) risk, a component of country risk, is the possibility that the actions of a sovereign government (e.g. nationalization or expropriation) or independent events (e.g., wars, riots, civil disturbances) affect the ability of the seller in that country to meet its obligations to the buyer. (We will examine political risk in greater detail in Units Three and Four.)

n

Commercial or credit risk of the seller as a result of funds misuse, bankruptcy, or any other improper business activity

Seller’s advantages and risks

The seller has all of the advantages in the cash-in-advance transaction and almost none of the risks. The seller can ship the goods whenever convenient and, in the meantime, enjoy the use of the buyer’s funds.

Citibank’s role

Citibank has minimal involvement in a cash-in-advance transaction. However, it can derive fee income from transactions associated with funds transfer, foreign exchange (if required), and cash management.

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The advantages and risks of a cash-in-advance transaction and the role of Citibank are illustrated in Figure 2.1.

CASH IN ADVANCE The seller receives cash from the buyer prior to shipment.

Advantages BUYER

n

None

Risks

n

Buyer has no control over goods Buyer loses use of funds paid to the seller Seller may refuse to, or be unable to, ship the goods Political risk in the seller’s country Seller’s commercial or credit risk

n

None

n n

n

n

SELLER

n

n

CITIBANK

n

Ships goods when convenient Enjoys use of buyer’s funds

Has minimal involvement in this payment option. However, it can derive fee income from transactions associated with funds transfer, foreign exchange (if required), and cash management.

Figure 2.1: Cash in advance: Advantages and risks for buyer and seller and the role of Citibank

Situations

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Cash in advance transactions are arranged only in situations where the seller may have significant leverage and is able to dictate the terms of the deal — for example, when several buyers are competing for a limited product.

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TRADE SERVICES

Open Account Shipment before payment

A second method of paying for merchandise in an international trade transaction is the open account. The seller ships the goods, accompanied by the title documents (legal documents, e.g. insurance and transport documents, indicating proof of an individual’s ownership of the goods), before receiving payment or a written promise to pay (i.e. promissory note or draft). The shipper does not retain control of the goods. The flow of goods and cash in an open account payment option is illustrated in Figure 2.2.

(2) P a y m e n t On the agreed upon date, amount, currency

(1) Shipment of goods Title documents

The buyer may also be the end-user of the imported goods

Figure 2.2: Open account flow

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TRADE SERVICES

Buyer’s advantages and risks

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The buyer has all of the advantages and minimal risk in an open account transaction. The buyer: n

Retains control of the goods

n

Has time to generate cash from the sale of the goods before paying the seller to cover the period between the purchase and resale of the goods. Nevertheless, lack of timely payments may cause the facility to be discontinued. Note: The length of time between the shipment of goods by the seller and the payment by the buyer depends on the credit terms previously negotiated. The purchase order issued by the buyer or the contract of sale represents the terms and conditions of the negotiation.


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n

May not have to borrow and can use available cash on receipt of the merchandise

n

May incur foreign exchange risk if the imported goods are priced in the seller’s currency. The buyer may be unable to pay if its currency weakens sharply against the seller’s currency.

The seller has none of the advantages and all of the risks in an open account transaction. The seller: n

Has no control over the goods and the buyer’s willingness to pay for them

n

Incurs cross-border risk which may prevent an otherwise reputable buyer from sending payment. (Cross-border risk, a component of country risk, is the risk that, due to economic problems, political disturbances, or sovereign actions within the buyer’s country, it may become impossible to get money out of a country or to convert the buyer’s currency into a foreign currency — See Unit 4 for more details on risks).

n

May incur foreign exchange risk if the exported goods are priced in the buyer’s currency v-2.1

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TRADE SERVICES

n

Citibank’s role

May need to borrow to cover the period between shipment of the goods and receipt of funds. If the seller borrows at a floating rate, the seller may incur interest rate risk (the interest rate at which the seller borrows may rise to the point in which the transaction may become unprofitable for the seller).

Citibank has minimal involvement in an open account transaction. However, it can derive fee income from transactions associated with funds transfer, foreign exchange (if required), and cash management. Documentation for the shipment of the merchandise is handled outside banking channels. The advantages and risks of an open account transaction and the role of Citibank are shown in Figure 2.3.

OPEN ACCOUNT Buyer receives goods and pays later through an arrangement negotiated in advance with the seller

Advantages BUYER

n

Foreign exchange risk

n

Retains control over goods Pays when convenient May not have to borrow and can use available cash

n

None

n

No control over goods and buyer’s willingness to pay Cross-border risk Foreign exchange risk Interest rate risk

n n

SELLER

Risks

n n n

CITIBANK

n


Figure 2.3: Open account: Advantages and risks for the buyer and seller and the role of Citibank

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Situations

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The typical situations in which a seller would be willing to assume the above risks are when the contract is: n

Between parent companies and subsidiaries to facilitate intra-company trade

n

Between buyers and sellers with excellent long-term relationships

n

Between sellers and buyers, when sellers feel strong competitive pressures, especially in domestic markets

Cash in advance and open account are relatively simple procedures, but the risks involved are unevenly distributed between the buyer and seller. These two payment options are not suitable in transactions where the buyer and seller do not know each other very well, or the seller does not want to assume the credit risk and country risk when offering payment terms to the buyer. The other three payment options — on consignment, documentary collections, and letters of credit — may be more appropriate. These options reduce the risk to the seller and buyer and simplify the cash management aspects of the transaction. We examine these options in detail in the sections that follow.

On Consignment Seller ships goods but retains ownership

In an “on consignment” sale, the seller ships the goods to the importer while retaining ownership of the goods. The importer is referred to as the consignee who is actually an agent responsible for paying for the goods if and when the goods are sold.

Consignee’s advantages and risks

The prime advantage for the consignee is that the consignee pays only as the imported goods are sold. The consignee receives a fee for brokering the sale. There are no risks for the consignee.

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Citibank’s role

TRADE SERVICES

The key advantages for the seller are that the seller retains ownership of the goods until sold and uses the services of the consignee to intermediate the sale of the goods to the buyer. In terms of risks, the seller: n

Has limited control over the goods

n

Has no control over the consignee’s willingness to pay for goods

n

Receives payment only upon sale of goods

n

May incur cross-border risk of the consignee’s country

n

May incur foreign exchange risk

n

May incur commercial or credit risk

Citibank has minimal involvement in an “on consignment” transaction. However, it can derive fee income from transactions associated with funds transfer, foreign exchange (if required), and cash management.

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The advantages and risks of an “on consignment” transaction and the role of Citibank are shown in Figure 2.4.

ON CONSIGNMENT The seller ships goods to the consignee, but retains ownership. Payment is made if and when the consignee sells the goods

Advantages

Risks

CONSIGNEE

n

Pays only as goods are sold

n

None

SELLER

n

Retains ownership of the goods Consignee intermediates sale of goods to buyer

n

Has limited control over goods Has no control over consignee’s willingness to pay for goods Receives payment only upon sale of goods May incur: • Cross-border risk • Foreign exchange risk • Commercial or credit risk

n

n

n

n

CITIBANK

n


Figure 2.4: On consignment: Advantages and risks for the seller and consignee and the role of Citibank

Situations

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Seller should only grant consignment terms to a: n

Reputable consignee with good credit ratings

n

Consignee with whom the seller has a good credit history

n

Consignee whose country enjoys economic and political stability

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Documentary Collections Banks act upon instructions received

The fourth payment option, documentary collections, is a method by which a seller is able to collect payment from an overseas buyer through an intermediary bank. Banks act as intermediaries in facilitating the flow of the title documents and in the payment of the transaction.

Parties and process

There are four major parties involved: the seller, remitting bank (seller’s bank), buyer, and collecting / presenting bank (buyer’s bank). There are four major steps in a documentary collection: 1. The seller, after effecting shipment, forwards to the remitting bank (seller’s bank) the following documents covering the shipment — l

Written collection instructions

l

Draft (financial document which is a demand for payment), and/or

l

Commercial documents (e.g. commercial invoice, transport document, and any other document applicable to the collection transaction)

2. The remitting bank (seller’s bank), acting as an intermediary, transcribes the sellers’ collection instructions and forwards it to the collecting / presenting bank (buyer’s bank) along with the draft and/or commercial documents. 3. The collecting / presenting bank, acting as an intermediary, makes the draft and/or commercial documents available to the buyer for inspection and only delivers the original commercial documents in accordance with the remitting bank’s collection instruction. 4. The buyer, after inspecting the commercial documents, has three options: (i) to pay, (ii) to obligate itself to pay at a future date, or (iii) to refuse either to pay or to obligate itself to pay the accompanying draft.

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Seller requires immediate payment

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If the seller requires immediate payment of a collection and is not willing to extend financing to a buyer, the seller will use a sight draft. A sight draft is an order signed by the seller directing the buyer to pay a specified amount to the seller upon presentation of the draft. The document and cash flow for documents against payment is illustrated in Figure 2.5. n

After shipping the goods (1), the seller sends a sight draft with the commercial documents (transport documents, commercial invoice and any other document applicable to the collection transaction) to the collecting / presenting bank through the remitting bank (2,3).

n

The collecting / presenting bank releases the commercial documents to the buyer only upon payment of the sight draft (4). The buyer must effect payment of this draft to receive the commercial documents. The release of the documents to the buyer upon payment of a sight draft is known as documents against payment (D/P collection).

n

The collecting / presenting bank forwards the payment to the seller through the remitting bank (5,6). Citibank remitting bank

( 6 )$ ( 2 ) Sight draft and documents (1) (5)

( 3 ) Sight draft and documents in trust

( 4 ) Sight draft and documents (4) Citibank collecting / presenting bank

Figure 2.5: Documentary collection flow for documents

against payment (D/P collection)

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Seller extends financing

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If the seller extends financing to the buyer, the seller uses a time draft. A time draft is an order signed by the seller directing the buyer to pay a specified amount to the seller on a specified future date. The document flow for documents against acceptance (D/A collection) is illustrated in Figure 2.6. n

After shipping the goods (1), the seller sends a time draft with the commercial documents (transport documents, commercial invoice, and any other document applicable to the collection transaction) to the collecting / presenting bank through the remitting bank (2,3).

n

The collecting / presenting bank releases the commercial documents to the buyer only upon the buyer obligating itself to pay the accompanying draft. The buyer obligates itself to pay by placing the word accepted across the face of a draft followed by the maturity date and the buyer’s signature. The release of the commercial documents to the buyer upon its acceptance of the time draft is known as documents against acceptance (D/A collection) (4,5,6). These steps occur simultaneously.

n

The seller receives the accepted draft from the remitting bank and holds it to maturity (7); it may then be presented for payment under a D/P collection (Figure 2.5).

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Citibank remitting bank (7) Accepted returned to draft seller (2) Time draft and documents

(1) Goods

( 4 ) Time draft for acceptance *(5) Accepted time draft *(5) Documents released upon acceptance

(3) Time draft anddocuments in trust

(6) Accepted draft returned to seller

Citibank collecting / presenting bank

Figure 2.6: Documentary collection flow for documents against acceptance (D/A collection)

* Please note that these steps occur simultaneously.

Advantages and Risks to the Buyer, Seller, and Citibank Buyer’s advantages and risks

In a documentary collection transaction, the buyer’s advantage is that the buyer may refuse to: n

Pay for drafts and/or documents

n

Accept a time draft

In terms of risks, the goods may not meet the buyer’s specifications after payment and/or acceptance. Seller’s advantages and risks

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For the seller, the advantage is that the seller knows that the commercial and/or financial documents are controlled by the banks, acting as intermediaries, and are not delivered to the buyer until payment is made or a time draft is accepted by the buyer.

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A bank’s control of the documents reduces the seller’s risk in relation to the documents only; however, the seller may be exposed to:

Citibank’s advantages and risks

n

Cross-border risk

n

Foreign exchange risk

n

Interest rate risk

n

Commercial or credit risk

n

Costs resulting from the buyer’s refusal to pay. In this instance, the seller incurs the expense of storing goods in a foreign country while finding another buyer in that country (or in another country), or arranging for their return to the country of origin.

n

Loss of goods resulting from a time limit for holding goods in public storage. Regulations in many countries may restrict the number of days in which goods may be held in public storage. After that time, the goods may be sold at auction.

In a documentary collection transaction, Citibank facilitates the flow of the title documents and of the payment of the transaction. Citibank does not deal with goods and does not assume any credit risk — it acts only as an intermediary in the collection process. However, there are operational risks to consider: n

Citibank must follow the collection instructions issued by the seller; otherwise it may incur a financial loss.

n

Citibank must comply with US government regulations, in the US and abroad, or it may be exposed to fines, civil and criminal penalties, and negative publicity (See Unit 4).

n

Citibank must comply with foreign government regulations in their respective countries or it may be exposed to fines, civil and criminal penalties, and negative publicity.

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n

Citibank must safeguard negotiable instruments since they can be fraudulently endorsed and are freely negotiable in the open market. For instance, time drafts, after acceptance by buyers, become negotiable instruments and, as such, require safekeeping to protect Citibank from financial losses and customer dissatisfaction.

In exchange for the risks, Citibank has an opportunity to increase fee-based revenues and to take advantage of cross-sell opportunities in cash management. The advantages and risks of documentary collections for the buyer, seller, and Citibank are shown in Figure 2.7.

DOCUMENTARY COLLECTIONS The seller ships goods to the buyer. The seller’s draft and title documents are presented through the intermediary banks for payment.

Advantages BUYER

SELLER

n

May refuse to pay for drafts and/or documents

n

May refuse to accept a time draft

n

Commercial and/or financial documents controlled by banks

Risks n

Goods may not meet buyer’s specifications

n

Country, foreign exchange, interest rate, and commercial risks Buyer does not pick up documents or refuses to pay Time limit for holding goods in public storage in the event of non-acceptance of documents

n

n

CITIBANK

n

n

Fee-based revenues Cross-sell opportunities

n n

n

n

Not following collection instructions Not complying with US government regulations, in the US and abroad Not complying with foreign government regulations in their respective countries Not safeguarding negotiable instruments

Figure 2.7: Documentary collections: Advantages and risks for buyer and seller and risks for Citibank

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References

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The Uniform Rules for Collections (UCC), a publication of the International Chamber of Commerce (ICC), provides guidelines for parties / participants involved in collections transactions. Summary In international trade, buyers and sellers have different objectives: n

The buyer wants to ensure the receipt and quality of the goods while structuring a favorable payment schedule. As such, buyers prefer the “open account” payment option.

n

The seller wants to deliver the goods and receive payment as quickly as possible. As such, sellers prefer cash in advance.

Citibank has minimal involvement in those trade transactions associated with the first three payment options we discussed: “cash in advance,” “open account,” and “on consignment.” As a result, the Bank does not incur any direct risk. On the other hand, Citibank can derive fee income from related transactions such as funds transfer, foreign exchange (if required), and cash management. In terms of the fourth payment option, “documentary collections,” Citibank derives fee income from this payment option since it acts as an intermediary bank in facilitating the flow of the title documents and in the payment of the transaction. Citibank incurs operational risks since it must deal with documents and negotiable instruments. To check your understanding of the first four trade payment options, please complete Progress Check 2.1 and check your answers with the Answer Key. If you answer any questions incorrectly, please reread the corresponding text to clarify your understanding. Then, proceed to the next section of Unit 2 where we discuss the fifth and final payment option, “Letters of Credit.”

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PROGRESS CHECK 2.1


Question 1: In negotiating a trade transaction, the party with the most leverage will: _____ a) finance the seller. _____ b) be able to dictate the terms. _____ c) have none of the advantages. _____ d) incur foreign exchange risk.

Question 2: In a documentary collection, the banks: _____ a) monitor the quality of the goods shipped. _____ b) assume the buyer’s credit risk. _____ c) act as intermediaries in the collection process. _____ d) verify that the number of goods shipped agrees with the title document.

Question 3: An exporter receives a purchase order and payment for 1500 pairs of shoes. This is an example of which type of payment option? _____ a) Documentary Collections _____ b) Open Account _____ c) Cash in Advance _____ d) On Consignment

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ANSWER KEY

Question 1: In negotiating a trade transaction, the party with the most leverage will: b) be able to dictate the terms. Question 2: In a documentary collection, the banks: c) act as intermediaries in the collection process. Question 3: An exporter receives a purchase order and payment for 1500 pairs of shoes. This is an example of which type of payment option? c) Cash in Advance

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PROGRESS CHECK 2.1 (Continued)

Question 4: The bank holds shipping documents in its custody and will only deliver them to the buyer upon receipt of payment for the documents. If payment is not received, the intermediary banks will look for further instructions from the seller. This is an example of: _____ a) documents against acceptance. _____ b) cash in advance. _____ c) on consignment. _____ d) documents against payment.

Question 5: An exporter receives a purchase order for two million radios and ships the goods and title documents directly to the buyer before receiving payment for the goods. Which payment option is this? _____ a) Open Account _____ b) Documentary Collections _____ c) On Consignment _____ d) Cash in Advance

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ANSWER KEY

Question 4: The bank holds shipping documents in its custody and will only deliver them to the buyer upon receipt of payment for the documents. If payment is not received, the intermediary banks will look for further instructions from the seller. This is an example of: d) documents against payment.

Question 5: An exporter receives a purchase order for two million radios and ships the goods and title documents directly to the buyer before receiving payment for the goods. Which payment option is this? a) Open Account

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Question 6: A “cash in advance” transaction gives all of the advantages to the: _____ a) buyer. _____ b) seller.

Question 7: Identify the payment option(s) which expose the seller to the risk of nonpayment by the buyer. (Select all that apply.) _____ a) Cash in Advance _____ b) Open Account _____ c) Documentary Collections _____ d) On Consignment

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ANSWER KEY

Question 6: A “cash in advance” transaction gives all of the advantages to the: b) seller.

Question 7: Identify the payment option(s) which expose the seller to the risk of nonpayment by the buyer. (Select all that apply.) b) Open Account c) Documentary Collections d) On Consignment

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Question 8: What payment option(s) should the seller consider when his/her products are in high demand? (Select all that apply.) _____ a) Cash in Advance _____ b) Documents Against Acceptance _____ c) On Consignment _____ d) Documents Against Payment

Question 9: Identify the risk(s) faced by the seller when collecting payment from an overseas buyer. (Select all that apply.) _____ a) Country _____ b) Foreign Exchange _____ c) Commercial _____ d) Interest Rate _____ e) Operational

Question 10: What payment option(s) should the seller consider when the seller is willing to extend credit to the buyer? (Select all that apply.) _____ a) Cash in Advance _____ b) Open Account _____ c) Documents Against Acceptance _____ d) Documents Against Payment

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ANSWER KEY

Question 8: What payment option(s) should the seller consider when his/her products are in high demand? (Select all that apply.) a) Cash in Advance d) Documents Against Payment

Question 9: Identify the risk(s) faced by the seller when collecting payment from an overseas buyer. (Select all that apply.) a) Country b) Foreign Exchange c) Commercial d) Interest Rate

Question 10: What payment option(s) should the seller consider when the seller is willing to extend credit to the buyer? (Select all that apply.) b) Open Account c) Documents Against Acceptance

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Question 11: In what payment option does the seller use the services of an importer or responsible agent to intermediate the sale of the goods to the buyer? _____ a) Cash in Advance _____ b) Documents Against Acceptance _____ c) On Consignment _____ d) Documents Against Payment

Question 12: In what payment option(s) do banks derive fee income when facilitating the flow of title documents and of the payment of the trade transaction? _____ a) Cash in Advance _____ b) Documentary Collection _____ c) On Consignment _____ d) Open Account

Question 13: What is the most common type of risk incurred by banks in a documentary collection? _____ a) Foreign Exchange _____ b) Country _____ c) Operational _____ d) Interest Rate

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ANSWER KEY

Question 11: In what payment option does the seller use the services of an importer or responsible agent to intermediate the sale of the goods to the buyer? c) On Consignment

Question 12: In what payment option(s) do banks derive fee income when facilitating the flow of title documents and of the payment of the trade transaction? b) Documentary Collection

Question 13: What is the most common type of risk incurred by banks in a documentary collection? c) Operational

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Question 14: Banks acting as intermediaries of a trade transaction can derive more fee income from: _____ a) documents against payment. _____ b) documents against acceptance. _____ c) the “on consignment” option. _____ d) the “open account” option. Question 15: In which of the following situations would a seller grant consignment terms? (Select all that apply.) _____ a) Reputable consignee who is unknown to the seller _____ b) Between buyers and sellers with excellent long-term relationships _____ c) Between parent companies and subsidiaries to facilitate intracompany trade _____ d) Consignee with whom the seller has a good credit history and whose country faces economic and political stability Question 16: Chemco, one of the largest Mexican producers and exporters of chemical products, is scheduled to begin selling phosphate to QRS Chemicals, a company recently acquired by Chemco. In arranging financing terms, Chemco has offered its subsidiary a tenor of up to 90 days after shipment date. What is the best payment option for this trade arrangement? _____ a) Export Letter of Credit _____ b) Import Letter of Credit _____ c) Open Account _____ d) On Consignment _____ e) Documentary Collection v01/20/99 p02/12/99

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ANSWER KEY

Question 14: Banks acting as intermediaries of a trade transaction can derive more fee income from: b) documents against acceptance.

Question 15: In which of the following situations would a seller grant consignment terms? (Select all that apply.) d) Consignee with whom the seller has a good credit history and whose country faces economic and political stability Question 16: Chemco, one of the largest Mexican producers and exporters of chemical products, is scheduled to begin selling phosphate to QRS Chemicals, a company recently acquired by Chemco. In arranging financing terms, Chemco has offered its subsidiary a tenor of up to 90 days after shipment date. What is the best payment option for this trade arrangement? c) Open Account

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LETTERS OF CREDIT (L/C)

Bank assumes obligation to pay

The fifth major payment option covered in this unit, “letter of credit,” is an instrument issued by a bank to a named party which substitutes the bank’s creditworthiness for that of its customer. The letter of credit states the bank’s willingness to guarantee its customer’s credit and the bank’s conditional obligation to pay the party named in the letter of credit.

Parties to a Letter of Credit Several participants are involved in a letter of credit transaction:

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n

The applicant is the party that arranges for the letter of credit to be issued.

n

The beneficiary is the party named in the letter of credit in whose favor the letter of credit is issued.

n

The issuing or opening bank is the applicant’s bank that issues or opens the letter of credit in favor of the beneficiary and substitutes its creditworthiness for that of the applicant.

n

An advising bank may be named in the letter of credit to advise the beneficiary that the letter of credit was issued.

n

The paying bank is the bank nominated in the letter of credit that makes payment to the beneficiary without recourse, after determining that documents conform, and upon receipt of funds from the issuing bank or another intermediary bank nominated by the issuing bank.

n

The confirming bank is the bank which, under instruction from the issuing bank, substitutes its creditworthiness for that of the issuing bank. It ultimately assumes the issuing bank’s commitment to pay.

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Citibank’s role

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A bank may take on more than one role in a single letter of credit transaction. At least two banks are involved in most transactions — the bank in the applicant’s country and the bank in the beneficiary’s country. However, it is not unusual to find three, and sometimes four, different banks participating in one transaction. As a result of Citibank’s global network, Citibank can assume many roles in a single transaction. In a letter of credit transaction, banks deal only with documents; they have nothing to do with the goods. Revocable or Irrevocable Letter of Credit Letters of credit are issued either as “revocable” or “irrevocable.” Unless clearly designated revocable, a letter of credit is considered irrevocable.

Amended or canceled at any time

A revocable letter of credit is one that can be amended or canceled by the issuing or opening bank at any time without prior notice to, or agreement of, the beneficiary. It is seldom used.

Cannot be amended or canceled

An irrevocable letter of credit is one that is a definite commitment by the issuing bank to pay, provided the beneficiary complies with the terms and conditions of the letter of credit. An irrevocable letter of credit cannot be amended or canceled without the consent of the issuing bank, confirming bank (if the L/C is confirmed), and the beneficiary. Basic Letter of Credit Components

Required information

A letter of credit always includes the following basic components: n

Revocable or irrevocable designation

n

Beneficiary’s name and address

n

Aggregate amount in the specified currency. Letters of credit can be issued in any currency.

n

Expiration date and place of expiration

n

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Documents must comply with the terms and conditions of the letter of credit and must be consistent with all documentary requirements. A discrepancy represents any variation or difference between the requirements of the credit (text) and what is shown on the documents presented. A discrepancy can void the bank’s commitment to pay. In some cases, the bank may return the discrepant documents to the beneficiary with instructions to re-present corrected documents. If the beneficiary cannot re-present corrected documents, the paying bank, on the instruction of the beneficiary, requests approval from the issuing bank to waive the discrepancies and pay the beneficiary. In the event that the issuing bank refuses to waive the discrepancies, the beneficiary retains the ownership of the shipping documents and may seek settlement outside of the letter of credit.

COMMERCIAL AND STANDBY LETTERS OF CREDIT Payment for goods vs. payment for performance

The characteristics that we have described so far are common to any letter of credit; however, there are two major categories of letters of credit – commercial letters of credit and standby letters of credit. A commercial letter of credit is used as a payment method in conjunction with the movement of goods. A standby letter of credit is used as a monetary indemnification in relation to the performance of the Bank’s customer in an underlying contractual obligation with another party. We describe these two types of letters of credit in the pages that follow.

References

There are two publications published by the International Chamber of Commerce (ICC) which provide guidelines for parties / participants in letter of credit transactions: the Uniform Customs and Practice for Documentary Credits (UCP) and the International Standby Practices (ISP). While the UCP is utilized for both commercial letters of credit and standby letters of credit, the ISP is a more recent publication specifically suited and more appropriate to use for standby letters of credit.

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Commercial Letters of Credit When the beneficiary (seller or exporter) is in a position to dictate terms that minimize risk, and the applicant (buyer or importer) wishes to purchase goods without paying for them in advance, the beneficiary will require the applicant to provide a commercial letter of credit. A commercial letter of credit is an instrument that states the bank’s obligation to pay the beneficiary upon presentation of conforming documents evidencing that goods have been shipped. Citibank only pays the beneficiary if the required documents presented are in accordance with the terms and conditions of the letter of credit. Other terms

Transaction flow

In addition to the basic letter of credit components previously described, the following terms and conditions are also part of a commercial letter of credit: n

Presentation period for documents

n

Latest shipment date

n

Required documentation

n

Merchandise description

n

Origin of goods, place of shipment and destination, shipping terms (i.e. FOB, FCA, CFR, CIF  please refer to the latest edition of the ICC publication titled INCOTERMS 1990)

n

Reimbursement instructions (for bank use only)

The typical transaction flow of a commercial letter of credit is as follows: 1. The applicant (buyer or importer) initiates the request for a letter of credit. 2. The issuing bank (opening) issues the letter of credit and forwards it to the beneficiary directly or transmits it to the advising bank. v-2.1

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3. The advising bank authenticates and presents the letter of credit to the beneficiary. If the issuing bank nominates the advising bank to be its paying agent, the advising bank may also become the paying bank. The issuing bank may also request that the advising bank add its confirmation to the letter of credit. 4. The beneficiary ships the goods. 5. The beneficiary forwards the documents required under the terms and conditions of the letter of credit to the paying (confirming) bank. 6. The paying (confirming) bank examines the documents to ensure compliance with the terms and conditions of the letter of credit. If the documents comply, the paying bank receives funds from the issuing bank before releasing payment to the beneficiary. 7. The paying (confirming) bank forwards the documents to the issuing bank. Upon receipt, the issuing bank reexamines the documents to ensure compliance with the terms and conditions of the letter of credit. 8. The issuing bank debits the applicant’s account. 9. The issuing bank releases the documents to the applicant. The commercial letter of credit flow is illustrated in Figure 2.8.

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Figure 2.8: Commercial letter of credit flow

Settlements Under a Letter of Credit All commercial letters of credit must clearly indicate whether they are payable by sight payment, by deferred payment, by acceptance, or by negotiation. These are noted as formal demands under the terms of the commercial letter of credit. Sight payment

In a sight payment, the commercial letter of credit is payable when the beneficiary presents the complying documents and if the presentation takes place on or before the expiration of the commercial letter of credit.

Deferred payment

In a deferred payment, the commercial letter of credit is payable on a specified future date. The beneficiary may present the complying documents at an earlier date, but the commercial letter of credit is payable only on the specified future date.

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Acceptance

An acceptance is a time draft drawn on, and accepted by, a banking institution which promises to honor the draft at a specified future date. The act of acceptance is without recourse as it is a commitment to pay the face amount of the accepted draft.

Negotiation

Under negotiation, the negotiating bank, a third party negotiator, expedites payment to the beneficiary upon the beneficiary’s presentation of the complying documents to the negotiating bank. The bank pays the beneficiary, normally at a discount of the face amount of the value of the documents, and then presents the complying documents, including a sight or time draft, to the issuing bank to receive full payment at sight or at a specified future date.

Types of Irrevocable Commercial Letters of Credit There are three basic types of irrevocable commercial letters of credit. 1. Straight letter of credit A straight letter of credit usually involves three parties: an applicant, the issuing bank, and the beneficiary. The commitment of the issuing bank extends to the named beneficiary; the beneficiary presents the documents directly to the issuing bank or nominated paying bank for payment. 2. Negotiable letter of credit In a negotiable letter of credit, the issuing bank assures anyone who “negotiates” against conforming documents that it will be reimbursed under the terms and conditions of the letter of credit. The negotiating bank becomes a legal party to the letter of credit.

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Additional party: negotiating bank

In a negotiable letter of credit, the additional party to consider is the negotiating bank. This bank, usually unnamed in the letter of credit, elects to “negotiate” (purchase documents from, and advance funds to, the beneficiary) against presentation of the documents required by, and conforming to, the terms and conditions of the letter of credit.

Settlement under negotiable letter of credit

Generally, a negotiating bank negotiates documents and may provide advance funding to the beneficiary on a recourse basis. In effect, the negotiating bank extends a loan and charges a fee. If the issuing bank refuses to reimburse the negotiating bank for reasons other than discrepant documents, the negotiating bank can retrieve its funds from the beneficiary. From the beneficiary’s perspective, a negotiable letter of credit accelerates payment. 3. Confirmed letter of credit A confirmed letter of credit is typically used when a beneficiary may not be willing to rely on the credit standing (creditworthiness) of an issuing bank and/or on the political risk of the issuing bank’s country. The risks associated with the issuing bank’s country may affect the ability of the issuing bank to honor its obligations.

Commitment to pay without recourse

As a result, the beneficiary may insist not only that the issuing bank issues a letter of credit, but also may require that a bank in the beneficiary’s country adds its commitment to pay without recourse. This requirement is met by a letter of credit that is an irrevocable obligation of the issuing bank (buyer’s bank) which is confirmed by a bank in the beneficiary’s country. The bank in the beneficiary’s country adds its commitment to that of the issuing bank to honor drafts and documents presented in accordance with the terms and conditions of the letter of credit. This bank is referred to as the confirming bank.

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Confirmed, irrevocable letter of credit provides best protection to beneficiary

The confirming bank guarantees payment and assumes the credit and country risks of the issuing bank. A confirmed, irrevocable letter of credit provides the best protection to the beneficiary in mitigating the cross-border and commercial risks of the transaction.

Special Features of Commercial Letters of Credit Letters of credit may be structured to meet the particular circumstances of a transaction. Some special features include: revolving, red clause, back-to-back, transferable letters of credit, and assignment of proceeds. n

Credit available for fixed amount of time

Cumulative / non-cumulative

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Revolving Letters of Credit Instead of establishing one letter of credit for each shipment from the same seller, the buyer can open a revolving letter of credit which makes a fixed sum available for a specified amount of time to cover multiple shipments from a single seller. For example, a letter of credit with a total value of $600,000 may be structured to allow a seller to make six monthly shipments, each valued at $100,000. The seller may draw up to $100,000 after each shipment. Revolving letters of credit may be cumulative or noncumulative. In a cumulative revolving letter of credit, the $100,000 per month may be carried over into another month if, for some reason, the seller does not ship. In a non-cumulative revolving letter of credit, the $100,000 does not carry over from month to month.

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n

Cash advance (loan) to beneficiary

Red Clause Letters of Credit In this type of letter of credit, the buyer / applicant authorizes the designated bank to make a cash advance (loan) to the seller / beneficiary to purchase the goods or effect shipment under the letter of credit. The designated bank charges interest to the seller at the local rate, unless the letter of credit terms provide otherwise. It is referred to as a “red clause” simply because some banks historically printed this clause in red ink. Typically, it is used when the applicant and the beneficiary enjoy a close business relationship.

n

Possible collateral for second L/C

Back-to-Back Letters of Credit Two letters of credit used to facilitate the purchase of the same goods are called back-to-back letters of credit. The beneficiary of an irrevocable letter of credit may use it as collateral to open a second letter of credit. This second letter of credit is issued in favor of the ultimate manufacturer or supplier of goods needed for shipment under the first letter of credit. In a back-to-back letter of credit, the beneficiary of the first letter of credit provides security for his/her supplier by procuring the issuance, in favor of the supplier, of a second letter of credit. A back-to-back letter of credit is an instrument seldom used because of the credit and operational risks for the paying / confirming bank of the first (original) letter of credit. This bank becomes, in turn, the opening bank of the second letter of credit. Some of the problems with this instrument are as follows: •

The credit standing of the original beneficiary must be such to enable the original paying / confirming bank to open the second letter of credit without requiring any collateral dependency on the first letter of credit.

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•

The terms and conditions of the first and second letters of credit should NOT be mirrored. For instance, the expiration date of the second letter of credit would need to be several days less than the first letter of credit to accommodate the two presentations of documents.

•

There are issues involving the original beneficiary. For instance, suppose the second beneficiary presents the documents which meet the terms and conditions of the second letter of credit. As a result, the opening bank of the second letter of credit must pay.

•

Now, what happens if the original beneficiary does not present the documents or goes bankrupt? What if the original opening bank finds discrepancies with the presented documents and refuses to pay? How will the opening bank of the second letter of credit get reimbursed by the opening bank of the first letter of credit?

Whenever a “transferable” credit is necessary to execute a trade transaction, there are other instruments available that minimize a bank’s risk. These are transferable letters of credit and assignment of proceeds. n

Transferable Letters of Credit A transferable letter of credit involves less risk for the Bank than to a back-to-back letter of credit. It allows the beneficiary of the transferable letter of credit to request the nominated transferring bank to transfer, in whole or in part, the letter of credit to one or more second beneficiary(ies). The first beneficiary is typically a broker or middle person in the transaction and the second beneficiary(ies) is the ultimate supplier of the goods.

n

Assignment of Proceeds

Transfers credit to supplier

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Assignment of proceeds to a third party

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If the letter of credit is not transferable, an assignment of proceeds is another option available for the beneficiary to finance the purchase of goods from its supplier. With assignment of proceeds and in accordance with the provisions of applicable law, the beneficiary can instruct the paying bank to assign, partially or in total, the proceeds available under a letter of credit to a third party (assignee). The assignment of proceeds is not, itself, a letter of credit and the assignee is not a party to the letter of credit. The assignee is not entitled to payment under the letter of credit unless the beneficiary presents strictly complying documents under the terms and conditions of the letter of credit. If the beneficiary fails to submit complying documents, the assignee will not be paid the amount originally agreed to under the assignment of proceeds. Advantages and Risks of Commercial Letters of Credit

Applicant’s advantages and risks

The letter of credit assures the applicant (buyer) that the beneficiary (seller) will only be paid if the documents comply with the terms and conditions stated in the letter of credit. Since banks only deal with documents, and not with goods, the applicant still runs the risk that the merchandise may not be as it was represented in the documentation.

Beneficiary’s advantages and risks

The beneficiary enjoys four major advantages with a commercial letter of credit: 1. The beneficiary is assured of payment as long as it complies with the terms and conditions of the letter of credit. The letter of credit identifies which documents must be presented and the data content of those documents. The credit risk is transferred from the applicant to the issuing bank.

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2. The beneficiary can enjoy the advantage of mitigating the issuing bank’s country risk by requiring that the letter of credit be confirmed by a bank in its own country. That bank then takes on the country and commercial risk of the issuing bank and protects the beneficiary. 3. The beneficiary minimizes collection time as the letter of credit accelerates payment of the receivables. 4. The beneficiary’s foreign exchange risk is eliminated with a letter of credit issued in the currency of the beneficiary’s country. Citibank’s risks

In addition to operational risks, Citibank can incur other risks depending on the role(s) it plays in a letter of credit transaction. The roles and corresponding risks are as follows: n

Issuing Bank — faces a credit risk, as the bank that substitutes its creditworthiness for that of its customer. The issuing bank takes the full risk of the transaction until its customer, the applicant, is able to repay the full amount of the payment under the letter of credit. Operational risks also are associated with the issuing bank because the bank may misinterpret or overlook part of the applicant’s (customer’s) instructions. For instance, when the issuing bank opens the letter of credit, it may forget to include a beneficiary documentation requirement that had been specified as part of the applicant’s original instructions to the issuing bank. As a result, the beneficiary may get paid, but the issuing bank may not be able to be reimbursed by the applicant because the documentation requirements do not comply with the applicant’s original instructions.

n

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Advising Bank — faces operational risks such as delaying or failing to advise the beneficiary that a letter of credit has been issued. As a result, the letter of credit may expire or there may be insufficient time for the beneficiary to present the documentation under the terms and conditions of the letter of credit. In addition, the advising bank can be liable for failure to properly authenticate the apparent authenticity of the letter of credit. v-2.1

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n

Paying Bank — faces operational risks such as paying the beneficiary against nonconforming documents.

n

Confirming Bank — faces a credit risk as the bank that substitutes its creditworthiness for that of the issuing bank. The confirming bank takes the full risk of the transaction until its customer, the issuing bank, reimburses the full amount of the payment under the letter of credit. It also faces operational risks such as payment against nonconforming documents, and country risk of the issuing bank’s country.

n

Negotiating Bank — faces operational risks such as payment against nonconforming documents or misplacing any documentation that must be returned to the issuing bank. It also faces the credit risk of the beneficiary when advancing funds with recourse to the exporter.

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The advantages and risks of a commercial letter of credit for the applicant, beneficiary, and Citibank are shown in Figure 2.9.

COMMERCIAL LETTER OF CREDIT Goods are shipped to the applicant. The beneficiary’s draft and title documents are presented through the paying / confirming / issuing bank for payment.

Advantages APPLICANT

n

Assurance that payment will only be made upon beneficiary’s compliance with L/C terms and conditions

BENEFICIARY

n

Mitigation of commercial and country risks, if credit is confirmed

n

Currency conversion approved before goods shipped

n

Collection time minimized

n

Elimination of foreign exchange risk for L/C issued in currency of beneficiary’s country

n

Fee-based revenues

n

Cross-sell opportunities

CITIBANK (Risks may vary depending on bank role)

Risks n

Merchandise not as represented in documentation

n

Non-compliance with L/C terms and conditions

n

Issuing Bank – credit risk of the applicant and operational risks

n

Advising Bank – operational risks

n

Paying Bank – operational risks

n

Confirming Bank – credit risk of the issuing bank, operational risks, and country risk of the issuing bank’s country

n

Negotiating Bank – operational risks; credit risk of the beneficiary

Figure 2.9: Commercial letter of credit: Advantages and risks for applicant, beneficiary, and Citibank

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Import Letter of Credit and Export Letter of Credit The same letter of credit can be viewed as either an import or an export letter of credit, depending on the customer’s role in the trade transaction. For the applicant (importer or buyer), it is an import letter of credit; for the beneficiary (exporter or seller), it is an export letter of credit. Import Letter of Credit

From the importer’s or applicant’s perspective, the issuing bank (local bank) issues an import letter of credit for the account of the applicant (local importer or buyer), in favor of the beneficiary (foreign seller), to secure payment for foreign goods purchased.

Export Letter of Credit

From the exporter’s perspective, it is the same (import) letter of credit opened by the issuing bank on behalf of the beneficiary. This letter of credit is viewed by the advising / confirming / paying / negotiating bank as an export letter of credit for the account of an overseas buyer of the exporter’s goods, in favor of the exporter, as payment for goods purchased. The differences between the two perspectives are shown in Figure 2.10.

IMPORT Letter of Credit

EXPORT Letter of Credit

Applicant (Importer)

Customer’s Role

Beneficiary (Exporter)

Applicant’s bank

L/C Opened by For the Account of

Applicant

In Favor of

Beneficiary Foreign goods purchased

As Payment for

Local goods sold

Figure 2.10: Import Letter of Credit vs. Export Letter of Credit

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Standby Letters of Credit The second major category of letter of credit, standby letter of credit, is an instrument that secures the beneficiary against loss resulting from the failure of the bank’s customer to perform a contractual obligation, financial or nonfinancial, that the customer has with the beneficiary. This means that the bank promises to make a monetary payment under certain conditions specified in the letter of credit. While a commercial letter of credit is usually payable against the presentation of specified documents evidencing the shipment of goods, documents required in a standby letter of credit may consist simply of the beneficiary’s statement that the bank’s customer has defaulted in certain obligations that the customer has with the beneficiary. The bank does not investigate the underlying facts of the transaction and it pays against documents only. Standby letters of credit typically do not require the submission of shipping documents and are rarely used as a payment mechanism for the movement of goods. Other terms

Types of standby letters of credit

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In addition to the basic letter of credit components previously described, the following terms and conditions are also part of a standby letter of credit: n

Required documentation

n

Reimbursement instructions (for bank use only)

There are two basic types of standby letters of credit issued either as revocable or irrevocable: guarantee and payment. They are outlined in Figure 2.11, page 2-50. Later we will describe other legal forms of guarantee that are commonly used outside the US in place of a standby letter of credit.

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Standby Letter of Credit: Guarantee Type Form of protection to cover performance under a contract

The guarantee type standby letter of credit, issued only as irrevocable, may be used as a form of protection to cover performance, financial or nonfinancial obligation, under a contract. This instrument protects the beneficiary financially in the event that the bank’s customer fails to perform under the contract mentioned in the letter of credit. Otherwise, the beneficiary may draw those funds available under the letter of credit. It is referred to as a “standby” letter of credit because it provides financial protection to the beneficiary if the applicant defaults on the terms of the contract or agreement. The guarantee type can be used in just about any business transaction that requires a financial indemnification such as:

Example of security for advance payments

n

In lieu of bid, performance, and surety bonds

n

In lieu of bank guarantees

n

To support another bank’s guarantee or undertaking

n

To provide security for advance payments

Suppose a government agency advances $1 million to a construction company for materials to build a hospital. The government agency requires the contractor to have its bank issue a standby letter of credit to cover the advance in case the contractor goes out of business or disappears with the money. If the contractor defaults, the agency can draw the $1 million from the contractor’s bank under the standby letter of credit. If the contractor performs as expected, the agency never draws under the letter of credit.

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Standby Letter of Credit: Payment Type Functions as a payment mechanism for different conditions

The payment type standby letter of credit functions as a payment mechanism under specified terms and conditions. Payment may be triggered by virtually any mechanism agreed upon by the applicant and the beneficiary. A standby letter of credit issued as a payment vehicle can be either revocable or irrevocable, depending on the applicant’s objective. n

n

If revocable, the payment under the standby letter of credit may be issued to cover: • Salary payments •

Intercompany payments

•

Expense payments

If irrevocable, the payment under the standby letter of credit may be issued: • As payment of principal and/or interest on bonds •

In lieu of stock transfer contracts A stock transfer contract refers to those transactions in which the securities holder wishes to contract for the sale of securities, at a selling price established today, with delivery and payment to be made at a future date. If the beneficiary (securities holder) presents conforming documents (e.g., sight draft along with the endorsed securities), the standby letter of credit assures that the beneficiary will be paid.

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•

To pay progress payments

•

To pay any type of periodic payment obligation (e.g. rent, lease, alimony, insurance premiums)

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In Lieu of Bid, Performance and Surety Bonds

Irrevocable

Guarantee

In Lieu of Bank Guarantees

To Support Another Bank’s Guarantee of Undertaking

To Provide Security for Advance Payments

Standby Letters of Credit

Salary Payments (Abroad)

Revocable

Intercompany Payments

Expense Payments

Payment Type

Payment of Principal and/or Interest on Bonds

Irrevocable

In Lieu of Stock Transfer Contracts

To Pay Progress Payments

Figure 2.11: Types of Standby Letters of Credit

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To Pay Any Type of Periodic Payment Obligation

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Advantages and Risks of Standby Letters of Credit Applicant’s advantages and risks

Some of the advantages of a standby letter of credit for the applicant are as follows: n

The applicant may not have to commit funds to collaterize the transaction.

n

The instrument is widely accepted in the marketplace as a financial indemnity.

n

The instrument is less costly than other indemnification instruments such as surety bonds.

The applicant will always run the risk that the beneficiary may not perform honestly, ethically and legally. The applicant has to accept the risk of the beneficiary’s integrity. Beneficiary’s advantages

The beneficiary enjoys three major advantages with a letter of credit: 1. The beneficiary may enjoy the advantage of mitigating the issuing bank’s country risk by requiring that the letter of credit be confirmed by a bank in its own country. That bank then takes on the country and commercial risk of the issuing bank. 2. The beneficiary’s foreign exchange risk is eliminated with a letter of credit issued in the currency of the beneficiary’s country. 3. The beneficiary is assured of payment as long as it complies with the terms and conditions of the letter of credit. The letter of credit identifies which documents must be presented and the data content of those documents. The credit risk is transferred from the applicant to the issuing bank.

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Citibank’s risks

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In addition to operational risks, Citibank can incur other risks depending on the role(s) played by Citibank in a standby letter of credit transaction. The roles and corresponding risks are as follows: n

Issuing Bank — faces a credit risk, as the bank that substitutes its creditworthiness for that of its customer. The issuing bank takes the full risk of the transaction until its customer, the applicant, is able to repay the full amount of the payment under the letter of credit.

n

Advising Bank — faces operational risks such as delaying or failing to advise the beneficiary that a letter of credit has been issued. As a result, the letter of credit may expire or there may be insufficient time for the beneficiary to present the documentation under the terms and conditions of the letter of credit. In addition, the advising bank can be liable for failure to properly authenticate the letter of credit.

n

Paying Bank — faces operational risks such as paying the beneficiary against nonconforming documents.

n

Confirming Bank — faces a credit risk since the confirming bank takes the full risk of the transaction until its customer, the issuing bank, reimburses the full amount of the payment under the letter of credit. It also incurs operational risks and country risks of the issuing bank’s country.

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The advantages and risks of a standby letter of credit for the applicant, beneficiary and Citibank are shown in Figure 2.12.

STANDBY LETTER OF CREDIT The beneficiary’s draft and documents are presented through the paying / confirming / issuing bank for payment.

Advantages APPLICANT

BENEFICIARY

CITIBANK (Risks may vary depending on bank role)

n

May not need to commit funds to collaterize the transaction

n

Instrument widely accepted in the marketplace

n

Instrument less expensive than other indemnification instruments

n

Mitigation of commercial and country risks, if credit is confirmed

n

Elimination of foreign exchange risk for L/C issued in currency of beneficiary’s country

n

In case of default, ease of payment settlement

n

Fee-based revenues

n

Cross-sell opportunities

Risks n

Beneficiary may draw prematurely or present fraudulent documents

n

Non-compliance with L/C terms and conditions

n

Issuing Bank – credit risk of the applicant; operational risks

n

Advising Bank – operational risks

n

Paying Bank – operational risks

n

Confirming Bank – credit risk of the issuing bank, operational risks, and country risk of the issuing bank’s country

Figure 2.12: Standby letter of credit: Advantages and risks for applicant, beneficiary and Citibank

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Other Legal Forms of Guarantee Legal forms of guarantee: bonds vs. letters of guarantee

There are different legal forms of guarantee issued by banks located outside the US – bonds and (letters of) guarantee. These instruments represent the issuing bank’s commitment, made at the request of its customer, to pay a third party upon the occurrence of an assured event. They are contingent liabilities of the bank, which become absolute liabilities when the stated contingency occurs. In the event an appropriate claim for payment is made, the bank makes payment and seeks reimbursement from its customer. By issuing the guarantee, the bank substitutes its creditworthiness for that of its customer. Although the terms bond and (letters of) guarantee may be used interchangeably, there are some distinctions: n

A letter of guarantee or guarantee is a promise made by one party (the bank) on behalf of some other party (the bank’s customer and principal) that payment will be made to a third party (the obligee) at some future date. In the event that the bank’s customer does not make good its obligation to pay, the bank undertakes that it will make such payment. Guarantees are generally issued to assure financial, rather than nonfinancial contractual, obligations.

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n

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A bond is a commitment made by one party (the bank) to another party (the obligee) pledging to cover for financial loss caused by the act of default of a third party (the obligor – the bank’s customer). A bond is normally issued to assure performance of a nonfinancial contractual obligation, e.g. an obligation to provide goods or services under a contract with another party. Some of the common types of bonds are: •

Bid bond – an instrument designed to ensure that the tenderer (e.g., supplier) will honor its commitment to a buyer when bidding for a construction or supply contract. The tenderer submitting a bid requests its bank to issue a bid bond in favor of the buyer as beneficiary. In the event the tenderer’s bid is accepted and the tenderer fails to sign the contract, the bid bond is normally payable against the buyer’s statement that the bank’s customer, the tenderer, failed to sign the contract.

•

Performance bond – issued when the contract has been awarded. It is an instrument designed to ensure that the contractor (e.g. supplier) will perform and execute the contract in accordance with all its terms and conditions. A performance bond gives the buyer an indication of the contractor’s creditworthiness and, in the case of default, is payable on demand.

•

Surety bond – designed to ensure financial compensation to the buyer if the supplier does not perform contractually as agreed. It is an instrument issued by insurance and surety companies for one of the parties involved in a contract, arbitration, and judgment who is required to post bond.

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Letters of Guarantee vs. Standby Letter of Credit

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Whether for an advance payment guarantee or bond (e.g., the contractor requires an advance payment on the contract price to finance operations), bid bond, or performance bond, the (letter of) guarantee is the instrument of preference in many countries. Although banks in the United States are not permitted to provide bank (letters of ) guarantee, they are allowed by the regulatory agencies to substitute standby letters of credit in lieu of (letters of) guarantee, mitigating what would otherwise be a serious shortcoming for US exporters. When a guarantee is required, the US bank can ask its foreign subsidiary, branch, or correspondent bank to open a (letter of) guarantee on the US bank’s behalf. The US bank then backs up its request for a (letter of) guarantee from the foreign bank with its own standby letter of credit. The terms and conditions stated in a standby letter of credit are critical to the document. If they are not clearly defined and a dispute arises between the beneficiary and the bank’s customer, then the bank may have to play the difficult role of arbitrator. To avoid such a position, standby letters of credit, unlike a bank (letter of) guarantee, always include very specific instructions which define all of the prerequisites for drawing against the standby letter of credit. We have described certain legal forms of guarantee that are commonly used outside the US in place of a standby letter of credit. Note that these other forms of guarantee are not usually issued by Citibank. Summary A letter of credit is an instrument that substitutes a bank’s creditworthiness for that of its customer, the applicant. It also provides the bank’s conditional obligation to pay the party named in the letter of credit (the beneficiary). The letter of credit offers a certain degree of protection to both parties, applicant and beneficiary; hence, it is the preferred payment mechanism in trade.

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A letter of credit may be issued either in revocable or irrevocable form and will be considered irrevocable if it is not clearly designated as one or the other. A revocable letter of credit may be altered or canceled by the issuing bank at any time; an irrevocable letter of credit cannot be amended or canceled without the express permission of the parties involved – beneficiary and intermediary banks. A letter of credit assures the applicant that the beneficiary will only be paid if the documents presented by the beneficiary comply with the terms and conditions of the letter of credit. If the beneficiary complies exactly with the terms and conditions of the letter of credit, and if the letter of credit is confirmed, the beneficiary will be protected against the applicant’s credit risk and the issuing bank’s country and credit risks. When the letter of credit is issued in the currency of the beneficiary’s country, the beneficiary is protected against foreign exchange and cross-border (transfer and convertibility) risk. (Transfer and convertibility risks are covered in more detail in Unit 4.) A bank incurs operational risks and any other risk depending on the role(s) played in a letter of credit transaction. As the issuing bank, it faces the applicant’s credit risk; as the advising / negotiating / paying bank, it faces operational risks; and as the confirming bank, it faces the issuing bank’s credit and country risks. The applicant of a letter of credit has the advantage of not always needing to commit funds to collaterize the transaction and enjoying the use of an instrument which is widely accepted in the marketplace and less costly than other indemnification instruments. However, the applicant runs the risk that the beneficiary may draw prematurely or present fraudulent documents.

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In terms of the beneficiary’s advantages, when the beneficiary submits documents in accordance with the terms and conditions of the letter of credit, the bank becomes obligated to pay. The beneficiary can mitigate the issuing bank’s country risk by requiring that the letter of credit be confirmed by a bank in its own country. If the letter of credit is issued in the currency of the beneficiary’s country, the beneficiary also eliminates its foreign exchange risk. In this section we examined the differences between the two major categories of letters of credit, commercial and standby. A commercial letter of credit is used to facilitate the payment of goods in a trade transaction. It is essentially an agreement whereby a bank assumes a conditional obligation, in behalf of the applicant (buyer or importer), to make payment to a beneficiary (seller or exporter) against the presentation of specified documents by the beneficiary evidencing the shipment of goods. A standby letter of credit is used as a monetary indemnification associated with the performance of the bank’s customer in relation to an underlying contractual obligation with a third party. It protects a third party, the beneficiary, from loss resulting from the failure of a bank’s customer, the applicant, in performing some contractual obligation. To check your understanding of the fifth trade payment option, letters of credit, please complete Progress Check 2.2 and check your answers with the Answer Key. If you answer any questions incorrectly, please reread the corresponding text to clarify your understanding. Then, proceed to the final section of Unit 2, “Financial and Commercial Transaction Documents,” where you will learn about different types of trade documents.

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PROGRESS CHECK 2.2


Question 1: Which party typically adds its promise to pay under a confirmed letter of credit? _____ a) Buyer _____ b) Bank in the beneficiary’s country _____ c) Bank that issued the letter of credit _____ d) Beneficiary

Question 2: Typically, under what conditions will the paying bank pay the seller under a commercial letter of credit? (Select all that apply.) _____ a) Seller presents to the paying bank the documents that meet the L/C terms and conditions _____ b) Buyer confirms receipt of the goods _____ c) Buyer presents the title document and guarantees to the issuing bank _____ d) Buyer places sufficient funds in his or her account with the issuing bank _____ e) Paying bank receives funds from issuing bank or its agent bank

Question 3: The best protection for the seller is provided by a(n): _____ a) straight letter of credit. _____ b) open account. _____ c) revolving letter of credit. _____ d) confirmed, irrevocable letter of credit.

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ANSWER KEY

Question 1: Which party typically adds its promise to pay under a confirmed letter of credit? b) Bank in the beneficiary’s country

Question 2: Typically, under what conditions will the paying bank pay the seller under a commercial letter of credit? (Select all that apply.) a) Seller presents to the paying bank the documents that meet the L/C terms and conditions e) Paying bank receives funds from issuing bank or its agent bank

Question 3: The best protection for the seller is provided by a(n): d) confirmed, irrevocable letter of credit.

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Question 4: Identify the type of commercial letter of credit used by an importer with multiple scheduled payments: _____ a) Revolving, irrevocable letter of credit _____ b) Confirmed, irrevocable letter of credit _____ c) Negotiable, import letter of credit _____ d) Red clause, straight letter of credit

Question 5: A commercial letter of credit whereby the beneficiary has the right to request that it be made available to one or more parties and is less risky to the nominated advisory / confirming bank, is known as a: _____ a) red clause letter of credit. _____ b) transferable letter of credit. _____ c) back-to-back letter of credit. _____ d) clean letter of credit.

Question 6: In a letter of credit, banks deal: _____ a) only in goods, not with documents. _____ b) only with documents, not in goods. _____ c) with documents and in goods. _____ d) only with documents, not in goods, as long as it is a standby letter of credit

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ANSWER KEY

Question 4: Identify the type of commercial letter of credit used by an importer with multiple scheduled payments: a) Revolving, irrevocable letter of credit

Question 5: A commercial letter of credit whereby the beneficiary has the right to request that it be made available to one or more parties and is less risky to the nominated advisory / confirming bank, is known as a: b) transferable letter of credit.

Question 6: In a letter of credit, banks deal: b) only with documents, not in goods.

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Question 7: In a straight letter of credit, the parties involved are always the: _____ a) applicant, issuing bank, and beneficiary. _____ b) applicant, issuing bank, paying bank, and beneficiary. _____ c) applicant, issuing bank, negotiating bank, and beneficiary. _____ d) applicant, issuing bank, advising bank, and beneficiary.

Question 8: An exporter and importer are about to close a large trade deal but the issuing bank is unknown to the exporter. What commercial letter of credit would best meet the needs of the exporter to minimize its risk? _____ a) Negotiable _____ b) Confirmed _____ c) Straight _____ d) Back-to-Back

Question 9: For each role that a bank plays in a commercial letter of credit, identify one or more of the most common risks associated with the role. _____ a) Issuing Bank

1. Credit risk of the applicant

_____ b) Advising Bank

2. Operational risk

_____ c) Paying Bank

3. Credit risk of the issuing bank

_____ d) Negotiating Bank

4. Foreign exchange risk

_____ e) Confirming Bank

5. Interest rate risk 6. Political risk 7. Credit risk of the beneficiary

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ANSWER KEY

Question 7: In a straight letter of credit, the parties involved are always the: a) applicant, issuing bank, and beneficiary.

Question 8: An exporter and importer are about to close a large trade deal but the issuing bank is unknown to the exporter. What commercial letter of credit would best meet the needs of the exporter to minimize its risk? b) Confirmed

Question 9: For each role that a bank plays in a commercial letter of credit, identify one or more of the most common risks associated with the role. 1,2_ a) Issuing Bank:

Credit risk of the applicant, Operational risk

2 _ b) Advising Bank:

Operational risk

2 _ c) Paying Bank:

Operational risk

2,7_ d) Negotiating Bank: 2,3,6 e) Confirming Bank:

Operational risk, Credit risk of the beneficiary Operational risk, Credit risk of the issuing bank, Political risk

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Question 10: A seller, who will have a letter of credit opened in his favor, does not have funds to purchase the goods from his supplier and does not qualify for a bank loan. What would be the least complicated letter of credit to be issued that would enable the seller to obtain the goods? _____ a) Revolving _____ b) Back-to-Back _____ c) Transferable _____ d) Red Clause Question 11: Match the type of standby letter of credit with the application. Use G for guarantee and P for payment. _____ a) In lieu of a bid bond _____ b) In lieu of bank guarantees _____ c) Salary disbursements _____ d) Principal and/or interest on bonds payments _____ e) Security for advance payments Question 12: A standby letter of credit is different from a commercial letter of credit because a: _____ a) commercial letter of credit requires the beneficiary to present shipping documentation to draw against the letter of credit. _____ b) standby letter of credit is always revocable. _____ c) commercial letter of credit does not have an expiration date. _____ d) standby letter of credit can be viewed as either an import letter of credit or an export letter of credit.

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ANSWER KEY

Question 10: A seller, who will have a letter of credit opened in his favor, does not have funds to purchase the goods from his supplier and does not qualify for a bank loan. What would be the least complicated letter of credit to be issued that would enable the seller to obtain the goods? c) Transferable

Question 11: Match the type of standby letter of credit with the application. Use G for guarantee and P for payment. G

a) In lieu of a bid bond

G

b) In lieu of bank guarantees

P

c) Salary disbursements

P

d) Principal and/or interest on bonds payments

G

e) Security for advance payments

Question 12: A standby letter of credit is different from a commercial letter of credit because a: a) commercial letter of credit requires the beneficiary to present shipping documentation to draw against the letter of credit.

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Question 13: What option is available to a beneficiary who is in need of financing to pay its supplier, but does not wish to issue another letter of credit or change a letter of credit already opened in its favor? _____ a) Revolving _____ b) Back-to-Back _____ c) Transferable _____ d) Assignment of Proceeds

Question 14: Select the one correct tenor for each settlement. _____ a) Sight Payment _____ b) Negotiation _____ c) Deferred Payment _____ d) Acceptance

1. Payment is made immediately to the beneficiary when complying documents are presented 2. Payment is made to the beneficiary at a specified future date 3. Payment is made immediately to the beneficiary, normally at a discount, upon presentation of the complying documents

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ANSWER KEY

Question 13: What option is available to a beneficiary who is in need of financing to pay its supplier, but does not wish to issue another letter of credit or change a letter of credit already opened in its favor? d) Assignment of Proceeds

Question 14: Select the one correct tenor for each settlement. _____ 1 a) Sight Payment _____ 3 b) Negotiation _____ 2 c) Deferred Payment _____ 2 d) Acceptance

1. Payment is made immediately to the beneficiary when complying documents are presented 2. Payment is made to the beneficiary at a specified future date 3. Payment is made immediately to the beneficiary, normally at a discount, upon presentation of the complying documents

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Question 15: Match each of the five customer needs to one of the three instruments that will best meet the need. _____ a) A seller who is shipping to a buyer on open account may expect the buyer to provide a bank assurance that payment will be made when due. _____ b) A company may need to support a foreign subsidiary in its local borrowing needs. A foreign lending bank has indicated a willingness to accommodate the subsidiary’s borrowing needs if such borrowings are backed by a prime international bank. _____ c) A company may be interested in bidding on a sale of goods to a certain buyer. The buyer’s invitation to bid includes a stipulation that all bidders must post a bond or promise to establish financial responsibility and to assure that, if awarded the bid, the bidder will enter into a firm contract. _____ d) A company may enter into a contract to supply services in which the buyer requires the supplier to post a bond or ensure that, if the supplier fails to perform and execute the contract in accordance with all its terms and conditions, a monetary compensation will be made. _____ e) In the course of a project, a buyer may be required to make progress payments to the supplier. The buyer may require that the supplier obtain a bank guarantee that, in the event of nonperformance by the supplier, the buyer will be reimbursed for all of the progress payments. _____ f) As part of a divorce settlement, one of the parties requires alimony payments under a letter of credit by the other party who has moved to a distant country. The condition is that if the party receiving alimony marries, the other party is no longer under obligation to continue the payments. What is the appropriate letter of credit for this situation? Instruments available: 1. Standby letter of credit, irrevocable, payment type 2. Standby letter of credit, irrevocable, guarantee type 3. Standby letter of credit, revocable, payment type v01/20/99 p02/12/99

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ANSWER KEY

Question 15: Match each of the five customer needs to one of the three instruments that will best meet the need. _____ 1 a) A seller who is shipping to a buyer on open account may expect the buyer to provide a bank assurance that payment will be made when due. _____ 2 b) A company may need to support a foreign subsidiary in its local borrowing needs. A foreign lending bank has indicated a willingness to accommodate the subsidiary’s borrowing needs if such borrowings are backed by a prime international bank. _____ 2 c) A company may be interested in bidding on a sale of goods to a certain buyer. The buyer’s invitation to bid includes a stipulation that all bidders must post a bond or promise to establish financial responsibility and to assure that, if awarded the bid, the bidder will enter into a firm contract. 2

_____ d) A company may enter into a contract to supply services in which the buyer requires the supplier to post a bond or ensure that, if the supplier fails to perform and execute the contract in accordance with all its terms and conditions, a monetary compensation will be made. _____ 1 e) In the course of a project, a buyer may be required to make progress payments to the supplier. The buyer may require that the supplier obtain a bank guarantee that, in the event of nonperformance by the supplier, the buyer will be reimbursed for all of the progress payments. _____ 3 f) As part of a divorce settlement, one of the parties requires alimony payments under a letter of credit by the other party who has moved to a distant country. The condition is that if the party receiving alimony marries, the other party is no longer under obligation to continue the payments. What is the appropriate letter of credit for this situation? Instruments available: 1. Standby letter of credit, irrevocable, payment type 2. Standby letter of credit, irrevocable, guarantee type 3. Standby letter of credit, revocable, payment type

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Question 16: A letter of credit may be viewed as an import or export letter of credit, depending on the perspective a given party has of the transaction. Match the following parties with how they would view the same letter of credit in a trade transaction. _____ a) Issuing Bank

1) Import Letter of Credit

_____ b) Beneficiary

2) Export Letter of Credit

_____ c) Advising Bank _____ d) Buyer _____ e) Seller _____ f) Applicant _____ g) Paying Bank _____ h) Confirming Bank

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ANSWER KEY

Question 16: A letter of credit may be viewed as an import or export letter of credit, depending on the perspective a given party has of the transaction. Match the following parties with how they would view the same letter of credit in a trade transaction. _____ 1 a) Issuing Bank

1) Import Letter of Credit

_____ 2 b) Beneficiary

2) Export Letter of Credit

_____ 2 c) Advising Bank _____ 1 d) Buyer _____ 2 e) Seller _____ 1 f) Applicant _____ 2 g) Paying Bank _____ 2 h) Confirming Bank

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FINANCIAL AND COMMERCIAL TRANSACTION DOCUMENTS

Many documents facilitate the exchange of goods and services. In this section you will learn about the different financial and commercial documents necessary for different trade transactions.

Financial Documents A financial document may be a check (cheque), draft (bill of exchange), or promissory note. We describe them below.

Check A check must be drawn on a bank and can be payable only at sight.

Draft / Bill of Exchange Order to pay

A draft or bill of exchange (the terms are used interchangeably) is a written order to pay a sum of money. A draft, the most common document involved in the payment of trade transactions, represents a commitment to pay for goods when cash terms are not used. The seller (drawer), who is the beneficiary of the payment, generates the draft drawn on the party (drawee) who has agreed to make the payment. The drawee (buyer) may be a person or business who owes money to the drawer (seller), or it may be the bank that is responsible for making payment under a letter of credit.

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Sight and time drafts

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There are two types of drafts: “sight” and “time.” n

With a sight draft, the payment is made at “sight” or when the draft is presented.

n

The time draft commits the buyer to release the funds after a fixed period of time, such as thirty, sixty, or ninety days. For example, the buyer may want to purchase goods from the seller, but cannot pay the seller until the goods are resold. The time draft gives the buyer time to sell the goods and receive the money needed to pay the seller. A time draft drawn under a letter of credit is usually drawn on the negotiating bank by an exporter, which originates a bankers’ acceptance (see Unit 3).

Promissory Note Promise of payment

A promissory note is the most frequently used borrowing instrument in banking. By signing a note, the borrower acknowledges receipt of the money and commits to repay it, with or without interest, in a lump sum or in installments. A promissory note has most of the same features as a draft or bill of exchange. The main difference is that it represents a direct promise of payment by the person who signs the note, rather than an order to pay. A promissory note is an “I owe you,” whereas a draft is a “you owe me.”

Negotiable instruments

Checks, bills of exchange, and promissory notes are the three main types of negotiable instruments since they are often used as payment devices in international trade. Promissory notes and accepted bills contain an unconditional promise to pay a specified sum of money. That promise can be bought and sold by endorsing and handing over the piece of paper on which it is written.

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Commercial Documents A commercial document may be an invoice, bill of lading, insurance document / policy, or other shipping document. Commercial Invoice Billing document

A commercial invoice is a billing document issued by the seller and addressed to the buyer. It describes the goods or services, their price, and any other charges or relevant information about the transaction. The commercial invoice does not give title to the goods. Because it is a billing document, precise terms must be used and it only can be amended by a separate debit or credit note. Bill of Lading

Title document

A bill of lading is a transportation or shipping document issued by the transportation company when moving goods from the seller to the buyer. The bill of lading provides: n

Receipt for the goods delivered to the carrier for shipment

n

Contract of carriage of the goods from the place of receipt to the place of delivery listed in the bill of lading

n

Evidence of title to the goods

The name of the bill of lading indicates the kind of transportation:

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n

Ocean or marine bill of lading for shipments over water

n

Air waybill for air transportation

n

Truck bill of lading for transportation by truck

n

Rail bill of lading for shipments by rail

n

Intermodal bill of lading when more than one type of transportation is necessary

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Insurance Document / Policy Coverage for losses

The insurance document (policy) provides coverage for any losses or damages to the merchandise incurred when in transit. Either the importer or the exporter obtains coverage, depending on who has title to the goods during shipment. The policy states all the risks that are covered and the length of coverage. The time period is usually from the date when the seller delivers the goods to the shipping agency until the estimated time of arrival of the goods at the buyer’s warehouse. Unless otherwise stated in the letter of credit, an insurance policy should: n

Financially cover the risks mentioned in the letter of credit

n

Not be dated after the shipment date, or have an inception date (beginning of validity period) prior to shipment date

n

Be denominated in the same currency as the letter of credit

n

Cover at least 110% of the total cost of the goods for delivery to warehouse

n

n

Be in negotiable form  signed and endorsed Be issued by an insurance company, underwriter or their agents, and not by an insurance broker

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Other Documents Depending on the needs of the buyer and the characteristics of the merchandise, one or more other documents may be required.

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n

A certificate of origin states where the goods were manufactured or grown. It is usually issued by an official or an independent party such as a Chamber of Commerce. The certificate serves as proof for the buyer to obtain fiscal credit or exchange benefits in the buyer’s country because of special trade treaties between countries.

n

A weight list indicates the gross and net weights per package or volume and the total gross and net weight of the overall cargo.

n

A packing list, used by customs for inspection purposes, indicates the contents of each package being shipped and accompanies the cargo. The packing and weight lists may be combined to form a single document.

n

An inspection certificate is required by importers for merchandise of great value and quality. For example, a buyer purchasing steel of a certain grade or quality may request an inspection certificate indicating the grade of steel. A designated professional or company inspects the merchandise upon delivery to the shipping company or just before shipment and issues the inspection certificate.

n

A quality certificate, similar to the inspection certificate, is issued by an expert who verifies that the merchandise to be shipped agrees with the description shown on the transport document and the commercial invoice. The quality certificate can replace the inspection certificate.

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Sometimes the quality certificate has to be approved by the embassy of the buyer’s country. Possible scenarios requiring embassy approval include:

n

•

The importer has had a bad experience with the supplier or other suppliers from that country

•

The importer is new to the business and lacks experience with offshore purchases

An analysis certificate, used for mineral or chemical purchases, verifies the percentage of each component. This information determines the pricing and possible usage of the raw materials. Bulk shipments of perishable goods such as crops and gases also require analysis certificates. The analysis certificate can replace the inspection certificate.

UNIT SUMMARY In this section, we examined the two types of documents necessary to conduct trade transactions: financial and commercial. These documents include: n

n

n

n

Draft (bill of exchange)  A written order to pay a sum of money Promissory note  Signed commitment to repay a sum of money Commercial invoice  Billing document issued by the seller to the buyer Bill of lading  Shipping document issued by the transportation company when moving goods. It provides evidence of title to goods.

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n

Insurance document  Policy to cover losses or damages to goods when in transit. It is obtained by the party that has title to the goods during shipping.

Additional documents may be required depending on the needs of the buyer and the characteristics of the merchandise. To check your understanding of trade documents, please complete Progress Check 2.3 and check your answers with the Answer Key. If you answer any questions incorrectly, please reread the corresponding text to clarify your understanding. When you have completed the Progress Check, continue with Unit 3: Trade Finance.

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PROGRESS CHECK 2.3


Question 1: The document that transfers title is the: _____ a) commercial invoice. _____ b) bill of lading. _____ c) draft. _____ d) certificate of origin.

Question 2: Which document covers the risks that may affect the merchandise from the time it is delivered by the seller until it is received by the buyer? _____ a) Insurance document _____ b) Analysis certificate _____ c) Commercial invoice _____ d) Quality certificate

Question 3: Which document is provided by the seller to the buyer and gives a description and cost of goods and/or services? _____ a) Analysis certificate _____ b) Inspection certificate _____ c) Weight list _____ d) Commercial invoice

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ANSWER KEY

Question 1: The document that transfers title is the: b) bill of lading.

Question 2: Which document covers the risks that may affect the merchandise from the time it is delivered by the seller until it is received by the buyer? a) Insurance document

Question 3: Which document is provided by the seller to the buyer and gives a description and cost of goods and/or services? d) Commercial invoice

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Question 4: A document that demands payment when it is presented is a: _____ a) commercial invoice. _____ b) sight draft. _____ c) time draft. _____ d) promissory note.

Question 5: Merchandise imports that are priced according to a quality criteria may require a(n): _____ a) certificate of origin. _____ b) shipping guaranty. _____ c) letter of indemnity. _____ d) inspection certificate.

Question 6: Which of the following documents are negotiable instruments? _____ a) Promissory Note _____ b) Commercial Invoice _____ c) Bill of Lading _____ d) Bill of Exchange

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ANSWER KEY

Question 4: A document that demands payment when it is presented is a: b) sight draft.

Question 5: Merchandise imports that are priced according to a quality criteria may require a(n): d) inspection certificate.

Question 6: Which of the following documents are negotiable instruments? a) Promissory Note c) `Bill of Lading d) Bill of Exchange

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Question 7: Place an F in front of the names of financial documents and a C in front of the names of commercial documents. _____ Bill of Exchange _____ Bill of Lading _____ Promissory Note _____ Commercial Invoice _____ Certificate of Origin _____ Weight List

Question 8: A document that represents the buyer’s commitment to pay is a: _____ a) commercial invoice. _____ b) sight draft. _____ c) time draft. _____ d) promissory note.

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TRADE SERVICES

ANSWER KEY

Question 7: Place an F in front of the names of financial documents and a C in front of the names of commercial documents. F

Bill of Exchange

C

Bill of Lading

F

Promissory Note

C

Commercial Invoice

C

Certificate of Origin

C

Weight List

Question 8: A document that represents the buyer’s commitment to pay is a: d) promissory note.

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Unit 3

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UNIT 3: TRADE FINANCE INTRODUCTION All trade transactions require some form of financing. If the seller allows the buyer time to pay for purchased goods, the seller must borrow money or finance that period through available cash. Conversely, if the seller requires cash on delivery, the buyer must cover the period between payment for the goods and the conversion of the goods into cash through a subsequent sale. In this unit, we examine the many factors that banks must consider in extending credit to customers (buyers and sellers). We then define the types of transactions which may require trade financing as well as the credit instruments that have been developed to meet these needs. From the perspective of a customer requiring pre- or export financing, we examine the structure and parties involved in export financing. You will see how trade financing is provided by banks acting independently, with government support, or in cooperation with other banks.

UNIT OBJECTIVES When you complete Unit 3, you will be able to:

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Understand the process of extending credit to customers

n

Identify trade financing options for trade transactions

n

Understand two trade financing products: bankers’ acceptance and forfaiting

n

Recognize funding structures and mechanisms used by export credit agencies

n

Understand how correspondent banks facilitate international trade

n

Recognize three trade products that are common in international correspondent banking relationships

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TRADE FINANCE

EXTENSION OF CREDIT The decision to extend credit to a customer is based on past experience and present conditions. While it is not a precise science, the credit decision does require consideration of specific issues. The goals of extending credit are to service the needs of the customer and to earn a profit for the lending bank. In this section, we examine the process of extending credit while achieving both goals.

Establishing Creditworthiness Risk that borrower may not repay

Whenever a bank extends credit, there is always a risk that the borrower may not repay the loan. For each credit request, the bank must gather all of the facts, analyze them, and make a decision about the creditworthiness of the customer. The process of extending credit begins with the bank asking some basic questions: 1. How much money does the customer want? 2. For what purpose is the money going to be used? 3. For how long does the customer need to borrow the money? 4. How does the customer plan to repay the money? 5. Does the customer’s business generate sufficient cash for repayment?

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In addition, the customer must provide specific information about its financial strength and reputation. The bank analyzes the customer’s financial statements in order to assess capacity and capital. The financial statements include the income statement, balance sheet, and cash flow report. These statements summarize the financial strength of an individual or company on any date and for any period of time. They should be prepared and signed by independent auditors. For more information on statement analysis, you can order the self-instruction workbook, Financial Statement Analysis, through the Training Coordinator in your country or the training area responsible for your region.

Identifying Risks Besides evaluating the customer’s creditworthiness, the bank also must consider the risks of lending in other countries. Country risk includes political (sovereign) and cross-border (transfer and convertibility) risk. Political (sovereign) risk

The political and economic environment of the borrower’s country must be determined before credit is extended. For example, a country may experience civil wars, riots, or revolutions that can affect world trade and the borrower’s ability to repay his/her obligations.

Convertibility risk

In international lending, one of the parties has a currency conversion exposure. US commercial banks usually extend loans in US dollars to foreign customers and want to be repaid in US dollars. When a borrower sells goods in a foreign country, payment will be in the currency of that country. Convertibility risk may occur if the central bank of, or the foreign exchange market in, the borrower’s country does not have the US dollars available to sell to the borrower to allow repayment of the loan.

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Transfer risk

TRADE FINANCE

Governments may change laws, regulations, or procedures which also may affect a borrower’s ability to repay loans. The borrower in the country may not be allowed to transfer funds in the foreign currency of payment to the place of payment. As a result, the bank must be knowledgeable about the situation in the borrower’s country before approving an extension of credit. We discuss risk in greater detail in Unit 4.

Setting Interest Rates Interest rate reflects degree of risk

As compensation for assuming risk, the bank charges a certain interest rate for the use of its funds. The interest rate represents a percentage that the bank charges the customer for using the borrowed funds for a predetermined time. The amount of interest reflects and compensates for the degree of risk assumed by the bank. If the risk is higher, or the term of the loan longer, then the interest rate is higher.

Fixed / floating interest rate

A fixed interest rate does not change during the life of the loan. A floating interest rate is reset periodically, depending on the existing market rate on the reset date. Loans may be funded with domestic dollars or Eurodollars. Eurodollars are US dollars deposited in a bank outside the US such as a foreign bank, an overseas bank of a US bank, or an International Banking Facility (IBF) (covered under “Use of Offshore Vehicles” later in this unit).

Prime rate

Each bank sets its own prime rate for domestically-funded loans. The prime rate is a floating rate that is the most favorable interest rate charged by a commercial bank on short-term loans to its most creditworthy customers. If a borrower is not a most creditworthy customer, the bank will quote an interest rate of prime plus a spread. Each bank’s prime rate is set at a level that covers the bank’s cost of funds, its operating expense, and includes a margin of profit. Citibank calls the prime rate its “base rate.”

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LIBOR

3-5

When loans are funded with Eurodollars, the bank borrows the Eurodollars, pays the London Interbank Offered Rate (LIBOR), and lends these dollars to its customer. LIBOR is also a floating rate and represents the interest cost to the bank to obtain funds in this market. These loans are quoted as “LIBOR + x percent p.a.” The “x percent p.a.,” called the “spread,” represents the bank’s earnings. The Eurodollars are time deposits and, therefore, LIBOR is quoted as a fixed rate based on tenor (30, 60, 90, 180, and 360 days, and beyond one year). For a loan with a maturity of over a year, the bank may take a Eurodollar deposit for six months at LIBOR and reprice the loan for successive six month increments. The borrower’s interest rate is fixed for each six month period and may change each time the deposit is renewed. Notice the difference in earnings between these two kinds of funding. The prime rate includes the cost of funds to the bank, plus an amount to cover the bank’s overhead, plus an amount to provide the bank with a profit. Since LIBOR only accounts for the cost of funds, the bank must cover its overhead, be compensated for the credit risk, and earn a profit from the increment charged over LIBOR (i.e. spread).

Establishing Credit Terms In addition to setting the interest rate, the decision to extend credit also involves establishing the terms of the credit. Different types of loans have been developed for customers that cannot qualify for credit based on their financial strength. Each customer’s financial situation is unique, and the bank tries to find the best solution to meet the customer’s needs.

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Secured loans

When the bank makes a secured loan, it requires possession of, or title to, some outside value in addition to the signing of a debt instrument. This collateral provides additional protection for the bank. Sometimes the provision of collateral results in the bank’s willingness to charge a lower interest rate. Other times, the bank will lend only if collateral is pledged. (Note that an unsecured loan is granted on the financial strength and reputation of the borrower. The debt obligations are not backed by pledged collateral or a security agreement. A security agreement is a document which links the collateral to a loan or credit facility.)

Guaranteed loans

Sometimes, a borrower may not qualify for a loan based on its own financial strength or have collateral available to secure the loan. In this situation, another individual, bank, or company can guarantee repayment of the loan to the bank. This is called a guaranteed loan. The guarantor is the third party that assumes responsibility if the original borrower fails to repay the loan. The bank makes the credit decision based on the guarantor’s creditworthiness. In international trade, the country risk of the guarantor also must be considered. When the guarantor is from the same country as the borrower, the same risks apply. If the guarantor is from a different country than the borrower, the bank makes its decision based on the country risk of the guarantor.

Determining the Type of Financing The nature of the transaction determines which type of financing should be used. The various types of financing available for different credit needs include short and medium term loans, lines of credit, and syndications.

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Short Term Loan Loan up to one year

A short term loan is a loan with a maturity of up to one year. The principal and interest are paid at maturity date and this is evidenced by a promissory note. As mentioned in Unit 2, a promissory note is a legal contract that formally recognizes the borrower’s obligation to repay the lender the loan amount, with interest, over a certain period of time or by a stated date. When the borrower is from a foreign country, the promissory note must be enforceable in the United States courts and also, if possible, in the court of the borrower’s country.

Medium Term Loan Maturity greater than one year

A medium term loan is a loan with a maturity greater than one year and less than five years. It is payable in installments and is evidenced by a credit agreement and a promissory note. If the bank implements a schedule of single or multiple disbursements (drawdowns) to the borrower, it should include the schedule of repayments (installments) by the borrower.

Line of Credit Short-term borrowings on demand

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A line of credit is an agreement with a bank for short-term borrowings on demand. It is the maximum amount a bank is willing to lend to a particular customer over a future period. Customers use a line of credit when they have a series of transactions to be financed over a period of time. In some cases, establishing a line of credit is more appropriate than approving a series of one-time loans.

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Syndication Loan made by several lenders

If a single bank is unwilling or unable to fund a single loan, it may invite several other banks to extend the loan jointly in order to spread the risks among the banks. A syndication is a loan made by several banks or lenders that form an association to assume the responsibility and share the risks of the loan. In a syndication, a lead bank manages the transaction, and all other banks in the consortium are disclosed to each other and to the customer (borrower). The customer must assess the counterparty risk of each member of the consortium. If one bank fails to provide its portion of the loan, the customer (borrower), not the lead bank, bears the risk. A smaller bank often joins a syndication to diversify its loan portfolio and to gain recognition as an international bank — a status which may generate new business opportunities, but which may also create risks that it may not be prepared to manage. Booking Transactions

Offshore vehicle: International Banking Facility (IBF)

An offshore vehicle, such as Citibank NY International Banking Facility (IBF), is used for booking international trade transactions. It is not a separate banking entity, but a separate group of accounts or bookkeeping systems set up by a US bank or a US branch of a foreign bank to record international banking transactions. Although IBFs are physically located in the US, they are not subject to either reserve requirements or assessments for deposit insurance. Unlike other US banking facilities, they may offer deposits denominated in currencies other than the US dollar. They also can receive deposits from, and make loans to, nonresidents of the US or other IBFs. The IBF is the offshore vehicle most frequently used for booking trade loans.

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Managing the Credit Monitoring the customer

The bank must remain in contact with the customer (borrower) during the disbursement of a credit to ensure that the customer receives the funds as directed on the loan agreement and that the funds are being used for the purpose stated in the loan agreement. The bank should closely watch the customer’s financial health. Delayed payments, information from trade sources of other late payments, or requests for additional short-term financing may indicate that the borrower is having difficulties. It is important to recognize problems and address them as soon as possible. Now that you have a feel for the bank’s credit process, we will look at the types of trade transactions that may require an extension of credit.

PURPOSES FOR TRADE FINANCING Trade financing is the process of making available extensions of credit or other financing to meet the needs of both the importer (buyer) and the exporter (seller). Parties to an international transaction usually buy and sell on either a cash or credit (deferred payment) basis. Even cash transactions, when payment is made on receipt of the goods, may require: 1) A term of credit from the completion of manufacturing / production to the receipt of payment – or – 2) Financing to provide the necessary capital to manufacture and/or assemble the goods to be exported

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Product / Service— limited suppliers

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If the exporter has a product / service in high demand due to a limited number of suppliers, it is most likely that the exporter will want to be paid in cash at the time of sale. In this case, either the importer has sufficient funds to pay the exporter based on the terms and conditions of the sale or the importer cannot pay within the timeframe designated by the exporter. If the importer cannot pay according to the terms and conditions of the sale, the exporter has the following options: n

Consider other importers able to meet the exporter’s payment terms

n

Insist that the importer obtain financing from a local or international bank to make the payment

n

Obtain financing for the buyer either through the exporter’s own bank or through government programs such as the export credit agency of the exporter’s country. (This is called buyer credit and is covered in more detail in the third section of this unit.)

n

Wait until the importer is able to sell the imported goods in order to generate the cash for payment

n

Provide credit to the importer by offering deferred payment terms (This is called supplier credit and is covered in more detail in the third section of this unit.)

Depending on the option, the exporter may want to obtain the necessary insurance coverage for those risks which prevent the importer from: n

Generating the funds

n

Converting its local currency to the exporter’s country currency

n

Transferring the currency to the exporter’s country

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If the exporter needs financing to produce the products, the exporter may obtain it from a local or international bank or through government programs offered by its own country. Product / Service — many suppliers

If the exporter (seller) has a commodity product / service that is offered by many suppliers, the exporter should be more willing to provide credit terms to the importer (buyer). If the importer can only pay at a future date, because the goods must be sold in order to generate the cash payment, the exporter can provide supplier credit financing. In this case, the exporter has the following two options: n

n

Receive payment by selling its receivable due from the importer (goods or services capable of being converted into cash, now or at a future date) to a bank Hold it as a receivable until payment date

Trade finance serves a variety of purposes such as pre-export financing, export financing, import financing, and inventory financing. Next, we define each of these transactions.

Pre-Export Financing Acquisition and preparation of goods for export

In pre-export financing, the exporter (seller) has a firm contract of sale but needs financing to acquire and prepare the goods for shipment. Manufactured or processed goods, as well as readily marketable staples (e.g. wheat, sugar, corn, coffee, copper, silver), may be financed. Lack of working capital financing is one of the greatest obstacles an exporter may face and often can prevent companies from filling export orders. For instance, a manufacturer lacks the resources to obtain financing domestically for an overseas sale. The company has already reached the borrowing limit on its domestic line of credit, and its domestic bank is unwilling to lend against a foreign contract and the foreign receivable it will generate. If unable to obtain the necessary pre-export working capital, the exporter will risk losing the sale to its overseas competitors.

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Citibank in Latin America offers a flexible financing approach called pre-payment of exports, a unique product of Brazil. Pre-payment of exports

Pre-payment of exports allows an exporter to obtain financing from foreign banks or directly from the importer. Depending on the exporter’s track record or current export sales contract, the exporter may obtain pre-payment of exports from Citibank. Once Citibank agrees with the exporter on the financing terms (e.g., tenor, amount, pricing, importer(s), documentation), Citibank advances the funds by remitting a US dollar payment order from any offshore vehicle (Citibank NY IBF, Citibank Nassau) to the exporter. The exporter closes a spot export foreign exchange contract with Citibank (or some other local bank as agreed in the initial negotiations). As a result, the exporter receives the local currency equivalent to be used for the purchase, manufacturing, and shipping of the goods. Once the exporter ships the goods in accordance with the schedule previously negotiated with Citibank, the exporter presents the shipping documentation to the bank for review and collection. Upon acceptance, the bank delivers the documentation to the importer and, in return, the importer pays Citibank NY. On the other hand, the exporter pays interest to Citibank NY (or any other vehicle as appropriate) on the advance it received based on the negotiated pricing and conditions (end-of-period, quarterly, semi-annually, upon each shipment, or as otherwise negotiated).

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Export Financing Interval between shipment and receipt of payment

In export financing, the exporter (seller) needs financing for the period between shipment of the goods and receipt of payment from the importer (buyer). The exporter can ship under an open account, documents against acceptance or documents against payment basis, or letter of credit. In this instance, the exporter (seller) is providing supplier credit to the importer (buyer).

Import Financing Financing to pay for purchased goods

In import financing, the importer (buyer) who is purchasing goods under a sight letter of credit or under other payment terms (open account, term letter of credit) may need financing to meet the required payment.

Inventory (Warehouse) Financing Inventory and sale of readily marketable staples

In inventory or warehouse financing, an exporter (seller) needs financing to hold readily marketable staples in storage and complete the sale of these staples to a buyer within the seller’s country or overseas. In reality, inventory or warehouse financing is a type of secured lending because the goods serve as collateral for the loan. The exporter (seller) must pledge to the bank a warehouse receipt covering the goods, issued by an independent third party. The warehouse receipt is a title document which states that a warehouse company is holding a certain quantity of a specific commodity and that the company will continue to hold these goods until the warehouse receipt is presented. At such time, the merchandise is returned in exchange for the warehouse receipt. Only readily marketable staples or commodities (such as oil) qualify for storage financing on an eligible banker’s acceptance basis (discussed under “Commercial Financing” in the next section).

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Summary A decision to extend credit requires the bank to establish the creditworthiness of the customer, identify the risks, set the interest rate, establish credit terms, select the type of financing, book the transaction, and manage the credit. Trade financing may be required by an importer when the exporter has a product or service that is in high demand. In this case, the importer may have to pay cash at the time of the sale. On the other hand, if there are many suppliers of a product or service, the exporter may have to extend credit to the importer in order to attract the customer’s business. In this case, the exporter may need financing until the receivable is paid. Actually, there are four potential elements of a trade transaction that may require trade financing — pre-export, export, import, and inventory.

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PROGRESS CHECK 3.1

Directions: Determine the one correct answer to each question unless directed otherwise. Check your answers with the Answer Key on the next page. Question 1: When a bank extends credit to finance a trade transaction, the spread charged by the bank reflects (select two): _____ a) LIBOR. _____ b) the creditworthiness of the borrower. _____ c) the degree of risk assumed by the bank. _____ d) the borrower’s line of credit.

Question 2: The prime rate is: _____ a) a fixed interest rate charged by a bank to its “prime” customers. _____ b) a floating interest rate that a bank pays to borrow Eurodollars. _____ c) an interest rate that only accounts for the bank’s cost of funds. _____ d) the best rate charged by a bank on short-term loans to customers with the highest credit ratings. Question 3: Select two types of loans that may be given to customers that cannot qualify for credit based on creditworthiness. _____ a) Loans that require possession of, or a title to, something of value _____ b) Obligations that rely on the sound financial health and reputation of the borrower _____ c) Loans backed by another bank _____ d) Loans with tenors of less than one year

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ANSWER KEY

Question 1: When the bank extends credit to finance a trade transaction, the spread charged by the bank reflects (select two): b) the creditworthiness of the borrower. c) the degree of risk assumed by the bank.

Question 2: The prime rate is: d) the best rate charged by a bank on short-term loans to customers with the highest credit ratings.

Question 3: Select two types of loans that may be given to customers that cannot qualify for credit based on creditworthiness. a) Loans that require possession of, or a title to, something of value c) Loans backed by another bank

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Question 4: LIBOR is a rate which banks may use to: _____ a) establish the acceptance discount rate. _____ b) quote a floating-rate loan to a customer. _____ c) set their fixed lending rates. _____ d) determine interest charges for unsecured loans.

Question 5: “Import financing” means that the: _____ a) seller needs financing to acquire and prepare goods for shipment. _____ b) seller needs financing for the period between shipment of the goods and receipt of payment from the buyer. _____ c) buyer needs financing to meet the required payment for the purchase of the imported goods. _____ d) buyer needs financing to store purchased goods prior to their sale.

Question 6: When a buyer requires financing to meet the required payment under a sight letter of credit, the transaction may be described as: _____ a) pre-export financing. _____ b) warehouse financing. _____ c) export financing. _____ d) import financing.

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ANSWER KEY

Question 4: LIBOR is a rate which banks may use to: b) quote a floating-rate loan to a customer.

Question 5: “Import financing” means that the: c) buyer needs financing to meet the required payment for the purchase of the imported goods.

Question 6: When a buyer requires financing to meet the required payment under a sight letter of credit, the transaction may be described as: d) import financing.

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Question 7: Exporters with firm sales contracts may need pre-export financing to provide: _____ a) adequate working capital to prepare goods for shipment. _____ b) a hedge against foreign exchange risk. _____ c) warehouse facilities prior to delivering the goods. _____ d) an extension of credit to the importer.

Question 8: Export financing: _____ a) is supplier credit extended by the importer to the exporter. _____ b) improves the exporter’s cash flow until payment is received from the importer for goods that have been shipped. _____ c) is obtained from the bank by the importer to fulfill the terms of a documentary collection. _____ d) can only be obtained by the exporter to finance an open account transaction.

Question 9: Inventory financing may be needed by the: _____ a) importer to increase its inventory. _____ b) exporter to purchase inventory for the production of goods. _____ c) importer who uses the goods to secure the loan. _____ d) exporter to store goods until completion of the sale.

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ANSWER KEY

Question 7: Exporters with firm sales contracts may need pre-export financing to provide: a) adequate working capital to prepare goods for shipment.

Question 8: Export financing: b) improves the exporter’s cash flow until payment is received from the importer for goods that have been shipped.

Question 9: Inventory financing may be needed by the: d) exporter to store goods until completion of the sale.

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Question 10: Transatlantic Imports is a Citibank customer and wants to pay for imported goods 120 days from the shipment date. However, the exporter demands payment at sight. What type of financing should Citibank provide? _____ a) Import financing to the importer _____ b) Pre-export financing to the importer _____ c) Import financing to the exporter _____ d) Pre-export financing to the exporter

Question 11: ABC Company, located in Korea, is a reliable producer and exporter of silicon chips. Due to company finances, they are having difficulty in meeting their commitment to provide Hi-Tec, Inc., a US importer, with 600,000 chips within the next two months. What type of financing would be the best solution for this situation? _____ a) Pre-export Financing _____ b) Import Financing _____ c) Export Financing _____ d) Inventory Financing

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ANSWER KEY

Question 10: Transatlantic Imports is a Citibank customer and wants to pay for imported goods 120 days from the shipment date. However, the exporter demands payment at sight. What type of financing should Citibank provide? a) Import financing to the importer

Question 11: ABC Company, located in Korea, is a reliable producer and exporter of silicon chips. Due to company finances, they are having difficulty in meeting their commitment to provide Hi-Tec, Inc., a US importer, with 600,000 chips within the next two months. What type of financing would be the best solution for this situation? a) Pre-export Financing

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TYPES OF EXPORT FINANCING We have seen that trade financing may serve a variety of purposes. In this section, we focus on export financing and examine several ways such financing may be structured. Remember, export financing from the exporter’s perspective is when the exporter (seller) needs financing between shipment of goods and receipt of payment; from the importer’s perspective, the importer (buyer) needs deferred payment terms for the goods or services that an exporter (seller) is providing. Export financing alternatives include: n

Commercial financing

n

Export Credit Agency (ECA)-supported financing

n

Private insurance-supported financing

Commercial Financing Small-scale export contracts

Commercial financing in export financing usually involves letters of credit, bankers’ acceptances, and forfaiting. It is most appropriate for financing small-scale export contracts with maturities usually under one year. We have already covered letters of credit, so we will now describe the use of bankers’acceptances and forfaiting for export financing. Recall, from Unit 2, that drafts may be drawn payable at “sight” or at a predetermined future point in time (normally anywhere from 30 to 180 days after “sight”).

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Time Draft

Suppose that an importer (buyer) requires a period of credit which the exporter (seller) is prepared to grant. This gives the importer time to sell some or all of the goods before having to pay. The exporter draws a time draft or bill of exchange on the importer with a usance period (a length of time allowed for payment). The importer then “accepts” the bill of exchange and returns it to the exporter.

Acceptance

An acceptance, therefore, is a time draft (bill of exchange) that represents a promise made by the buyer (drawee) to honor the instrument at maturity date. The buyer writes “accepted” over his/her signature. The act of acceptance is without recourse as it is a commitment to pay at maturity. The party is accepting or agreeing unconditionally to pay the time draft at a particular time and place.

Trade acceptance

In a trade acceptance, the exporter (seller) of the goods draws a time draft on the importer (buyer). It is accepted by the importer for payment at a specified future date. The payment of the time draft is not assured by the bank. The seller may require a guarantee or an “aval” if a bank is to cover the commercial risk. (This concept is discussed further in the “Forfaiting” section — see page 3-29). For instance, in the case of documentary collections, where the exporter (seller) provides 180-day terms, the exporter draws a 180-day draft on the importer (buyer), payable to either the seller or the collecting bank that represents the seller. A trade acceptance is created when the importer (buyer) accepts the 180-day draft which gives the buyer possession of the documents. The acceptor is the buyer who has the obligation to pay.

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Banker’s Acceptance Bank’s obligation to pay

A banker’s acceptance is a short-term credit instrument that is often used in international trade. It is a time draft drawn by the customer / obligor (e.g. an applicant of a letter of credit) on a bank “and accepted by the bank” and is called the accepted draft. This represents the bank’s obligation to pay another party (e.g. the beneficiary of a letter of credit) a stated amount on a predetermined future date. The creation of a banker’s acceptance is an extension of credit by the bank to its obligor. The bank is responsible for paying the face value of the acceptance at maturity even if the customer goes out of business. A banker’s acceptance is most commonly used in conjunction with letters of credit and is a mechanism for financing short-term trade. As with any extension of credit, the bank makes its decision based on the customer’s credit history, current financial condition, and risks involved. Since there is an active secondary market for bankers’ acceptances, the bank may subsequently sell the acceptances to an investor in the secondary market.

Application of Bankers’Acceptances

The following example illustrates the use of a bankers’ acceptance for export financing. Example

n

n

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A US exporter (seller) agrees to the terms of a sale of goods to a foreign buyer which require that the importer (buyer) open a letter of credit. The letter of credit is opened by the foreign bank and is advised through a US bank. The US exporter (seller), the beneficiary of the letter of credit, has offered 90-day financing to the importer (buyer). The seller presents documents to the paying bank and draws a draft that matures in 90 days. The value of the draft equals the cost of the goods which includes the exporter’s estimate of an interest rate for the 90-day period.

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n

n

The paying bank accepts the draft and the draft becomes a banker’s acceptance. The exporter (seller) owns the banker’s acceptance. The exporter (seller) may hold the banker’s acceptance and present it to the bank at maturity for payment, but, more likely, it will discount it with the bank.

Acceptances are popular as short-term investments, and banks normally keep them on their balance sheets (an active secondary market exists, composed of investors and banks). Use of the banker’s acceptance enables the exporter in the US to take advantage of the generally lower cost of US financing; the cost savings may be reflected in a lower purchase price for the buyer.

Pricing Price components

Acceptance financing contains two cost elements: 1. Acceptance Commission Rate (spread) When accepting a draft, a bank charges an acceptance commission to compensate for its assumption of the credit risk and to cover the administrative costs of the transaction. The amount charged depends on the bank’s assessment of the credit risk involved. 2. Acceptance Discount Rate (cost of funds) When the bank discounts an acceptance, remitting funds to the seller (drawer of the draft), it charges interest in the form of a discount from the face value. This rate is the bank’s charge for the cost of funds. The specific rate is determined by conditions present in the money markets at the time of discount.

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All-in rates

3-27

Acceptances are quoted on a discount basis, frequently as “all-in rates” that mask the actual acceptance commission rate. (The all-in rate is the acceptance commission rate plus the discount rate.) Eligible and Ineligible Banker’s Acceptance

A banker’s acceptance, accepted by a bank in the US, may be either eligible or ineligible for discount or purchase by a Federal Reserve Bank. Although the Fed actually stopped discounting acceptances in the late 1970s, the eligibility requirements remain important. The accepting bank does not have to maintain reserves against eligible bankers’ acceptances, even though they are kept on the bank’s balance sheet, and there is an active secondary market. Eligible banker’s acceptance

Ineligible banker’s acceptance

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To be “eligible,” the tenor of a banker’s acceptance cannot exceed six months (180 days). The acceptance must be self-liquidating and there can be no other financing for the same transaction. The merchandise must be in the “channels of trade,” which means that the goods are being manufactured, packaged, shipped, received, stored, or resold. An eligible banker’s acceptance must come from one of three transactions: n

Import or export of goods between the US and foreign countries and between foreign countries

n

Domestic shipment of goods within the US

n

Storage of marketable commodities in the US and/ or in foreign countries

If a banker’s acceptance has not been created from one of the eligible transactions, or if it involves a draft with a tenor of more than six months, it is considered an ineligible banker’s acceptance. By accepting an ineligible draft, the bank is simply extending a loan to its customer and must post reserves against it since the acceptance is not backed by the Federal bank. When the bank’s prime rate is high, the bank may use an ineligible banker’s acceptance as a way to make a loan at a lower rate than the bank’s prime rate.

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Both types of bankers’ acceptances are permissible and both are freely negotiable. Because the accepting bank is not required to post reserves against the eligible banker’s acceptance, it is more appealing to banks (they can be more freely discounted in the marketplace) and less expensive to the borrower (e.g. beneficiary). When pre-export expenses related to manufacturing are financed, bankers’ acceptances cannot be used to acquire raw materials and cover manufacturing costs. Risks

For the creation of the eligible banker’s acceptance transaction, there are three major sources of risk for the bank: n

Legal and Regulatory Risks

n

When the banker’s acceptance is initiated, the bank must comply with US regulations; otherwise, the bank may be exposed to fines, civil and criminal penalties, and negative publicity.

n

Credit Risk

n

Operational Risks When payment is made, the documents must be complete and properly authenticated. When documents do not conform, the bank is exposed to litigation and financial loss. When the bank discounts the acceptance, the bank may be exposed to financial loss if it uses the wrong rate or wrong time period.

In addition to letters of credit and bankers’ acceptances, there is a third option for the pure commercial financing of international trade. Let’s now examine forfaiting.

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Forfaiting Rights exchanged for discounted cash payment

“Forfaiting” is a term that comes from the French word à forfait, meaning to surrender or relinquish the rights to something. The exporter (seller) surrenders the right to any claim for payment on the goods delivered to an importer in return for a discounted cash payment for these same goods from a forfaiting institution.

Primary market

Forfaiting, therefore, is the purchase of debt instruments due to mature in the future that originated from the provision of goods and services, primarily export transactions. Their purchase is without recourse to any previous holder of the instruments. Forfaiting allows an exporter to offer extended terms to an importer (buyer). The exporter receives a bill of exchange or promissory note for the goods from the importer and then sells the note to a financial agent (forfaiter or forfaiting company). A bank, such as Citibank, may be the financial agent which purchases from the exporter (seller) and may decide to: n

Hold the bill of exchange or promissory note, taking the importer’s credit risk (may eliminate the need for bank guarantee) and the importer’s country risk

n

Resell through the forfait market

Secondary Market

As soon as a forfaiter has purchased forfaited assets, it has made an investment. The forfaiter may not wish to hold this asset until its maturity and may, therefore, resell the note to an investor who then becomes the forfaiter. Investors who buy / sell forfaited assets in this way operate in the “secondary market.”

Guarantor

Because the forfaiter is purchasing a debt instrument without recourse to the seller, the forfaiter is bearing all the risks of nonpayment by the importer. If the importer’s financial strength is inadequate and the importer does not have sufficient collateral to pledge, the forfaiter will require that another corporation or bank (guarantor) be chosen to guarantee payment to the forfaiter in the

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event of the importer’s nonpayment. Before its sale in the primary and/or secondary markets, the promissory note must be issued in an unconditional and negotiable form that completely separates debt repayment from any contract disputes between the buyer and the seller regarding performance or quality of the goods sold. Forfaiting applications

Forfaiting can be used for short-term or medium-term credit. The maturities range from six months to ten years, with periodic installment payments for the goods and services sold usually required by the forfaiters. While it can be arranged for smaller transactions, forfaiting is usually done for transactions of more than one million dollars. In theory, the paper may be denominated in any currency. However, currencies which are not freely convertible, and are restricted by control regulations, are not attractive to investors.

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A step-by-step example of a forfait transaction is illustrated in Figure 3.1, below.

Figure 3.1: Forfaiting flow

Transaction steps

The steps are as follows: 1. The exporter and importer agree on the deferred payment terms and the interest rate to apply on the settlement of a commercial contract. 2. The importer obtains a commitment from a bank to give its “aval” (unconditional and irrevocable guarantee) on the negotiable document (accepted draft / bill of exchange / promissory note) which represents the obligation of the importer.

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3. The importer informs the exporter of the name of the bank which agreed to give its aval to the importer’s indebtedness. 4. The exporter proposes business to a forfaiter, and obtains an offer from the forfaiter to buy the draft(s) or promissory note(s) at the quoted discount rate based on yield to maturity (YTM). Offers are generally firm and incorporate an option period (for example, 30 days) to allow the exporter to fully receive the documents to be discounted. Thus, the offer contains: n

A discount rate based on the YTM

n

The option fee (for example, 0.125% flat)

n

The commitment fee (for example, 0.10% per month) for the time from expiration of the option period until delivery of the documents

5. The exporter confirms with the forfaiter his/her acceptance of the offer and pays the option fee. 6. The exporter ships the goods. 7. The exporter draws a draft(s) on the importer and requests its acceptance, together with the bank aval. Alternatively, the exporter requests from the importer the promissory notes in favor of the exporter, with the same bank’s aval. 8. As the exporter awaits the guaranteeing bank’s avalization, as of the expiration of the option period, the exporter starts paying the commitment fee to the forfaiter until delivery of the documents. 9. The exporter delivers to the forfaiter the avalized bills of exchange (accepted drafts) or promissory notes. 10. The forfaiter discounts them and pays the exporter.

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11. The bills of exchange or promissory notes are further discounted and traded (partially or fully) in the secondary market without recourse. 12. At maturity, the final holder(s) of the document(s) present them to the importer and, if unpaid, to the guaranteeing bank for payment of the full face value of the document(s) , plus the interest mentioned thereon. NOTE: An aval is an unconditional guarantee placed on each of the indebtedness instruments, e.g. promissory note or bill of exchange. By placing an “aval” on the instrument, the bank commits itself unconditionally to pay should the maker or drawee default. In those countries where an aval is not recognized by local law, the bank may give a guarantee instead – usually on a separate document called a “letter of guarantee.” Example

As an example of forfaiting, assume an emerging markets customer (importer) wants six-year credit terms for a purchase totaling US$6MM, to be delivered in four semiannual shipments. The importer is sufficiently creditworthy to get a local bank to grant one of the following: n

An unconditional bank guarantee to pay the holder of the debt obligation (forfaiter)

n

An aval on the exporter’s bill of exchange that guarantees payment

The forfaiter and the emerging markets customer together negotiate directly with the customer’s bank to determine which debt instrument will be used. Next, the forfaiter discounts the debt instrument and, since the amount of the discount will be known in advance, it can be included in the selling price of the order. When the exporter presents a complete set of documentation proving that the shipment has left, the forfaiter pays the exporter 100 percent of the selling price – less the discount if it was included in the selling price. Such payment is made within two days of the presentation of shipping documents.

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The forfaiter then collects against the letter of credit directly from the emerging markets customer or from the customer’s bank. When compared to bankers’ acceptance financing, forfaiting presents several distinct advantages and disadvantages to the trading parties.

Advantages of Forfaiting To the exporter

To the importer

The basic advantages of forfaiting to the exporter are the speed and simplicity of the transaction. Additional advantages for the exporter (seller) include: n

Exporter receives immediate cash

n

Avoidance of credit and country risks

n

Improved business liquidity, reduced bank borrowing, and freedom to reinvest or use financial resources for other purposes

n

Relief from administration and collection problems

n

Simplicity and ease of arranging documentation

The basic advantage of forfaiting to the importer (buyer) is also the speed and simplicity of the transaction. In addition, forfaiting provides the importer with a(n): n

Alternative form of financing

n

Fixed interest-rate credit

n

Increased and diversified borrowing capacity

n

Rapid conclusion for a commercial contract

n

Elimination of the administrative and legal costs associated with credit loan agreements

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To the forfaiter

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The basic advantage to the forfaiter is that the transaction provides a crisp, marketable instrument with a bank obligation.

Disadvantages of Forfaiting To the exporter

To the importer

The disadvantages to the exporter are: n

Need to ensure that the importer obtains a guarantor that is satisfactory to the forfaiter

n

May have to absorb part of the discount from commercial profit

The disadvantages to the importer are: n

To the forfaiter

Payment of a guarantee fee (higher costs) charged by the guarantor (e.g. bank)

The forfaiter also is disadvantaged in several ways. These include: n

Risk of adverse interest rate changes (interest rate risk)

n

Credit risk on the actual obligor / guarantor and/or related country risk

Required Documentation

As mentioned earlier, the documentation for a forfait is relatively simple and quickly arranged. It consists of:

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n

A note or bill purchase agreement between the forfaiter and the exporter covering the terms and conditions of the purchase

n

Bills of exchange (drafts) or promissory notes

n

Letters of guarantee or aval

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n

Signature confirmations

n

Copies of exchange control approvals, if applicable

Summary In this section, we examined the first of three export financing alternatives: commercial financing, which usually involves letters of credit, bankers’ acceptances, and forfaiting. We focused on bankers’ acceptances and forfaiting. A trade acceptance is a time draft that has been accepted by the buyer for payment to the beneficiary at maturity. The payment of the time draft is not assured by a bank. A banker’s acceptance is a time draft that has been accepted by the bank for payment to the beneficiary at maturity. It is a short-term credit instrument commonly used in international trade. Forfaiting is a longer-term financing technique whereby the seller receives a discounted payment for its goods in exchange for the buyer’s promissory note. It allows the seller to offer extended terms to the buyer without having to wait for payment. Before continuing to the remaining two export financing alternatives (ECA and private insurance-supported financing) in our discussion of “Types of Export Financing,” please complete Progress Check 3.2 to confirm your understanding.

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PROGRESS CHECK 3.2

Directions: Determine the one correct answer to each question unless directed otherwise. Check your answers with the Answer Key on the next page. Question 1: Which trade financing product involves the purchase of a debt instrument without recourse to the party from whom it was purchased? _____ a) Forfaiting _____ b) Extension of credit _____ c) Bankers’ Acceptance

Question 2: Bankers’ Acceptances are: _____ a) generally used as medium-term credit for capital goods with maturities ranging from six months to ten years. _____ b) usually used by borrowers from foreign countries because they provide financing that is enforceable in the courts of the US and their home countries. _____ c) popular as short-term investments and, therefore, among the least expensive short-term financing alternatives. _____ d) short-term borrowings on demand that are used by customers when they have a series of transactions to be financed over a period of time.

Question 3: When the bank accepts a time draft, it: _____ a) may sell the acceptance to a third party investor. _____ b) eliminates credit risk. _____ c) is eligible to discount the acceptance with the Federal Bank. _____ d) extends credit to its customer for six months or more.

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ANSWER KEY

Question 1: Which trade financing product involves the purchase of a debt instrument without recourse to the party from whom it was purchased? a) Forfaiting

Question 2: Bankers’ Acceptances are: c) popular as short-term investments and, therefore, among the least expensive short-term financing alternatives.

Question 3: When the bank accepts a time draft, it: a) may sell the acceptance to a third party investor.

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Question 4: Select two criteria of an “eligible” banker’s acceptance. _____ a) Tenor of at least six months _____ b) Self-liquidating _____ c) Minimum annualized return of 10% _____ d) Transactions limited to five types _____ e) Merchandise in the “channels of trade”

Question 5: Which trade product is usually quoted with an “all-in” rate? _____ a) Extension of credit _____ b) Trade acceptance _____ c) Banker’s acceptance _____ d) Forfaiting

Question 6: Forfaiting improves business liquidity by allowing the exporter to: _____ a) offer extended payment terms to the buyer while receiving cash immediately. _____ b) take advantage of floating interest rate financing. _____ c) avoid paying the acceptance commission and passing its costs on to the buyer. _____ d) receive an aval on the negotiable document.

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ANSWER KEY

Question 4: Select two criteria of an “eligible” banker’s acceptance. b) Self-liquidating e) Merchandise in the “channels of trade” Question 5: Which trade product is usually quoted with an “all-in” rate? c) Banker’s acceptance Question 6: Forfaiting improves business liquidity by allowing the exporter to: a) offer extended payment terms to the buyer while receiving cash immediately.

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TYPES OF EXPORT FINANCING (Continued)

Export Credit Agency-Supported Financing We have seen that the commercial financing of international trade usually involves letters of credit, bankers’ acceptances, and forfaiting. We now look at a second type of export financing where governments, acting through their Export Credit Agencies (ECAs) and through Multilateral Agencies (MLAs), also facilitate international trade. They provide export financing both directly to borrowers and indirectly through cooperation with commercial banks. The involvement of ECAs and, to a large extent MLAs, depends on the: n

Types of risk of the importer’s country

n

Nature and origin of the underlying exports and services

n

Maturity of the financing required

n

Acceptability of the borrower’s underlying credit structure

While ECA-supported financing is driven by the exporter’s country, MLA-supported financing is handled at the importer’s country. The MLA is a worldwide institution not associated with a local government as in the case of ECAs. MLAs more often are involved with project financing rather than export financing. We discuss MLAs in greater detail later in this section.

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In Unit 1, we told you that ECA programs include guarantees, insurance for country and/or credit risk, guaranteed payment to commercial banks, and preferential fixed interest rate. We now look at these characteristics in more detail.

ECA Guarantee and Insurance Protection against nonrepayment by buyer

The ECAs offer protection to the lender (or exporter) against nonpayment by the buyer in one of two forms of coverage – guarantees and insurance. A guarantee typically implies 100 percent protection for the covered risks in an event of default. Insurance implies that the probability of coverage is less than 100 percent, with the lender (insured party) remaining at risk for the percentage not covered. Insurance is a contract between an insurer and an insured under which each has obligations to the other. Upon satisfaction by the insured of its obligations, including documenting that a claimable event has occurred, the insurer will pay the claim. Under either form of protection, the lender can choose to protect itself against country risk only or against both country risk and buyer non-payment (comprehensive cover). Cash Payment Requirement

Minimum of 15%

ECAs require from prospective buyers a cash payment equivalent to

a minimum of 15% of the price of an export contract. This limits the ECAs’ coverage to 85% of the export contract value. Sourcing from Multiple Countries

National content requirements

For those export contracts involving the sourcing from multiple countries, the export contract value includes all imported goods and services contracted by the buyer, regardless of the supplier’s sourcing. In most cases, a country’s ECA supports only export contract values of its own country’s goods and services.

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Local Costs Financing Limited to 15% of export contract value

Many overseas projects involve substantial in-country installation or construction expenditures which must be provided by the exporter as part of his/her contract. Sometimes, such expenditures involve sourcing of construction services from the buyer’s country. These expenditures may constitute a portion of the imported goods and services eligible for export credit support. ECAs permit financing of identified local costs in amounts not exceeding 15% of export contract value. Only in such cases is ECA financing permitted to cover the equivalent of 100% of the country’s export contract value.

Example

For instance, suppose a US exporter is awarded a contract totaling $120MM for supplying a turnkey power plant to China. The US export contract value is $100MM and the $20MM balance of the total contract value is for building part of the plant’s infrastructure. We know that EXIMBANK covers up to 85% of the US export contract value ($100MM) which, for this example, amounts to $85MM. The $15MM balance of the export contract value not covered by EXIMBANK has to be covered by the local bank(s) in China. On the other hand, ECA covers part of the identified local costs not exceeding 15% of the export contract value. In our example, the ECA will cover $15MM out of the $20MM for the local expenditures and the risks of the remaining $5MM have to be assumed by commercial banks (local or international). Funding Mechanisms There are three major types of funding mechanisms for ECA-supported export financing dealing with short-, medium-, or longterm contracts. These are direct lending (co-financing), deposit / relending, and interest make-up. We examine the role of commercial banks in each funding mechanism. Direct Lending –

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The ECA lends directly to the buyer (importer) and, as a result, there are no financing earnings (spread) opportunity for banks.

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Deposit / Relending – The ECA lends to the bank which, in turn, re-lends to a borrower–buyer (importer). This funding approach offers banks attractive fixed interest-rate funds, but the ECA usually limits the spread that the bank can add. Interest Make-Up – The ECA provides compensation to lending banks for the difference between market rates of funding and the ECA’s concessional terms for a specified export contract. The lending bank and the borrower enter into an agreement to finance the export contract at a fixed interest rate over a time period. The bank then enters into a separate agreement with the ECA. The ECA compensates the bank for the difference between its cost of funding plus spread and the fixed interest rate on the loan to the borrower. For instance, if the fixed interest rate on the loan to the borrower is 7.0 % and if the bank’s price is 7.5% (LIBOR at 6.50% plus a 1.0% spread), then the interest make-up would be 0.5% (7.5% - 7.0%).

Interest Rates: Floating and Fixed Interest rates

Lenders, whether they are financial institutions or exporters providing deferred payment terms of sale, charge the buyer interest on the loan or deferred payment terms. For those financings covered by an ECA guarantee or insurance, there is no restriction (floor or ceiling) placed by the ECAs on the interest rate charged. The interest rate will be a reflection of the risks (country only or comprehensive) being covered by the ECA, the risks being assumed by the lender, and the pricing quoted by the competition.

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Lender / borrower agree on basis for calculating rate

ECA-supported export credits can involve either a floating or a

Floating interest rates

Floating rates are adjusted periodically, usually semi-annually, on the dates when repayment installments of the loan principal are due. Most medium term floating rate loans use LIBOR as the base for calculation of the rate, and the lender then adds a pre-agreed margin (the spread) to the LIBOR rate to arrive at the “all-in” interest rate paid by the borrower.

Fixed interest rates

Fixed rates remain constant for the life of the financing. Financial intermediaries usually make fixed rate financing available for very large (greater than $50MM) financings. The rate, or the basis for calculating the rate, is established between the lender and borrower prior to any disbursements, usually prior to the loan documentation process.

Commercial Interest Reference Rate (CIRR)

Most ECAs provide official fixed rate financing support. The ECAs have established guidelines among themselves on how this fixed rate (called the Commercial Interest Reference Rate or CIRR rate) will be calculated so that the ECAs do not get into pricing wars. The CIRR rate used is typically the rate in effect at the time the ECA approves the export transaction as eligible for its support. This support may take the form of a direct fixed rate loan or an interest make-up to financial intermediaries.

fixed rate of interest. Whether the rate will be fixed or floating, the basis for calculating the rate is agreed upon between the lender and borrower as part of the negotiations between these two parties before the financing mandate is awarded to the lender.

A direct fixed rate loan is one which the ECA makes directly to the borrower without using a financial intermediary. For an interest make-up, the ECA provides the financial intermediary with a compensation for the difference between the CIRR rate (the rate charged to the borrower by the lender) and the lender’s cost of funds plus a small pre-agreed (with the ECA) spread. Under both the direct loan and the interest make-up, the borrower is paying the CIRR rate.

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Risk-related exposure fees

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All ECAs charge insurance premiums or guarantee fees to help offset future losses due to credit risk exposure. These fees may vary with country, credit risk, and with the duration of the transaction. Insurance Coverage If the exporter or lender is not prepared to take the country risk and/or

credit risk, the exporter should apply for insurance coverage. Insurance coverage, in turn, often determines the availability of financing for the exporter. For example, an ECA’s short-term program may provide insurance

which can be used to obtain financing for the export of consumer goods, small manufactured items, spare parts, and raw materials. The medium-term insurance program may facilitate the financing of such capital goods and services as mining and refining equipment, construction equipment, agricultural equipment, telecommunications, computer equipment, and manufacturing equipment. Types of coverage

ECAs offer coverage directly to a lender or to the exporter for certain

commercial and credit risks. Commercial / credit risk refers to a borrower’s ability to generate sufficient local currency to purchase the necessary amounts of foreign currency to repay the financing.

Extent of coverage

In most cases, the insurance applies to a maximum of 85% of the commercial contract. In certain cases, the percentage may be higher, but it applies to the contract value less any required cash payment. For instance, the US ECA medium and long-term programs require the buyer to make a 15% cash payment. These programs cover up to 85% of the contract value for items that are 100% US content but no less than 50%. The US ECA guarantees such items as US equipment, financing and legal fees (US-sourced and included in the contract), freight, insurance, and local costs (under certain conditions).

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Transaction Structures: Buyer Credit and Supplier Credit In a typical transaction structure, an ECA financing extends credit to the importer either directly, through a Buyer Credit, or indirectly, through a Supplier Credit.

Buyer’s Credit Financing Exporter’s bank lends directly to importer

In buyer’s credit financing, the exporter’s bank (e.g. Citibank) extends credit directly to a buyer (importer) of goods and services. The credit may also be fully or partially guaranteed or insured by an ECA. The cash payment (15%), if any, may be financed by the exporter or a bank, or paid in cash by the importer. The supplier (exporter) and the buyer (importer) agree on the commercial terms. The bank and the buyer agree on the financing terms. When the buyer receives the loan from the bank, the buyer pays the supplier. This process is shown in Figure 3.2.

SELLING COUNTRY Supplier (Exporter)

BUYING COUNTRY Establish commercial terms of trade

1

Buyer (Importer)

5 Payment

4

Export Credit Agency (EXIMBANK)

3

Applies for / receives insurance policy and / or preferential interest rate

Figure 3.2: Buyer’s credit financing

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Establish financing 2 terms

Citibank

Loan agreement / financing

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Supplier’s Credit Financing Importer’s debt instrument insured by ECA

In supplier’s credit financing, the supplier (exporter) offers financing to the buyer (importer) by giving credit terms to the buyer. The supplier usually sells a receivable (e.g. promissory note or bill of exchange) from an importer (buyer) to a bank for cash. An ECA guarantees or insures a portion of the receivable. The cash payment (15%), if any, may be financed by the exporter or a bank, or paid in cash by the importer. The step-by-step illustration of the process is presented in Figure 3.3.

SELLING COUNTRY

BUYING COUNTRY 1

Supplier (Exporter)

2

Applies for / receives insurance coverage for note / bill

Export Credit Agency

3

Promissory note / bill of exchange

Sells note / bill and assigns insurance rights 4

Payment

Buyer (Importer)

5

Principal and interest repaid at maturity

Citibank

Figure 3.3: Supplier’s credit financing

1. Once the buyer and the supplier agree on the commercial terms, the buyer issues promissory notes or bills of exchange in favor of the supplier. 2. The supplier accepts these notes and seeks insurance coverage from an ECA. The supplier is the original beneficiary of the insurance policy or guarantee from the ECA.

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3. The supplier sells the notes to a local bank and assigns the rights of the ECA coverage to the bank. 4. The supplier receives a discounted payment, and the bank becomes the holder of the buyer’s obligation to pay. 5. The buyer repays principal and interest to the bank. Exact terms and conditions offered by the ECAs frequently change. Trade officers need to be updated continually on current programs, policies, and rates offered by these agencies. Organization for Economic Cooperation and Development (OECD)

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In Figure 3.4, below, we summarize the characteristics of some of the major export credit agencies. In this figure, we make reference to the Organization for Economic Cooperation and Development (OECD) which is the international organization of the industrialized, market-economy countries. At OECD, representatives from Member countries meet to exchange information and harmonize policy with a view to maximizing economic growth within Member countries and assisting non-Member countries to develop more rapidly. As of 1997, there were 29 Member countries.

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Country

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Export Credit Agency Description

Type of Cover

Program

Currency of Cover

Canada

EDC – Export Development Corporation

Insurance

Buyer & Supplier Credit

Canadian Dollars & US Dollars

France

COFACE – Compagnie Française d’Assurance pour de Commerce Exterieur

Insurance


French Franc or main OECD currencies

Germany

HERMES – Hermes Ausfuhrgarantien undbuergschaften

Insurance


DM Contracts denominated in US dollars are also insured

Italy

SACE (Export Credit Agency) – Sezione Assicurazione Crediti alla Exportanzione

Insurance


Italian Lira and main OECD currencies


Japanese Yen and main OECD currencies

MEDIOCREDITO CENTRALE (Export Credit Funding Agency) Japan

Interest make-up

J-EXIM – Export-Import Bank of Japan

Guarantee

MITI – Ministry of International Trade and Industry

Insurance

Spain

CESCE – Compania Española de Seguros de Credito a la Exportacion

Insurance


Pesetas and main OECD currencies

Sweden

EKN (Export Credit Guarantee Agency) – Exportkreditnämnden

Insurance


EKX (Export Credit Funding Agency) – Swedish Exportkredit

Lending

Swedish Kronor and main OECD currencies

United Kingdom

ECGD – Export Credits Guarantee Department

Guarantee


British Pound and main OECD currencies

United States

EXIMBANK – Export-Import Bank

Direct Loan Guarantee Insurance


US Dollar and main OECD currencies

Lending

Figure 3.4: Export Credit Agencies by country: Type of Cover, Program, and Currency of Cover

Multilateral Agency (MLA)-Supported Financing As you learned in Unit 1, indirect government aid is often associated with MLA-supported financing. MLAs are more involved in project financing than financing for the export of goods and services.

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Project financing

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Project financing implies that the providers of finance look initially at the economics of a project such as projected cash flows, rather than the traditional financial strengths of the borrowers. Such projects are expected to generate sufficient cashflow to pay the interest and repay the principal which originally supported the project. Examples of suitable projects include power plants, mining, and telecommunications installations. Depending on the complexity and size of the project to be financed, various sources of funding can be applied. Normally, several different funding sources are required to complete the financial package. Many MLAs operate on a complementary basis with export credit agencies and commercial sources. The involvement of MLAs adds credibility to a project, thereby facilitating the process of raising financing. MLAs recognize the need to select projects that bring economic value

to the importer’s country. Improved project selection by MLAs is regarded as an important policy step together with the introduction of new measures in macroeconomics management in the countries concerned. Financing structure

MLAs lend for periods of up to 20 years with grace periods of five

years and charge interest at a margin above their cost of funds. MLAs rarely finance 100% of a project: approximately 50% is a rough guideline for loans, equity, or guarantees.

Private Insurance-Supported Financing Although ECAs insure many export transactions, the private sector also plays a role in providing coverage for country and limited commercial risks. We now look at this third type of export financing. Private insurers primarily focus on short-term trade transactions and are generally limited to terms of three years for medium-term transactions. Some well-known insurers, which we describe in Unit 4, include Lloyds of London and Citicorp International Trade Indemnity (CITI).

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Private insurance coverage places no limitation on the national content of products. Military or paramilitary goods are acceptable if the trade transaction meets a bank’s credit policy approval. Insurance policy exclusions exist to limit coverage. Contract Frustration for Export Financing

The predominant policy type is Contract Frustration which covers non-payment resulting from specific country risks. Coverage under the Contract Frustration entitles the exporter to receive payment in the following instances: n

Coverage usually requires the bank to take some percentage of the risk

n

Can be used to cover pre- or export financing or import financing

n

Can cover loans or drafts purchased as well as letters of credit

EXPORT FINANCE: STRUCTURING THE DEAL The structure of export financing (commercial, ECA-supported, or privately insured) ultimately will reflect the results of the credit and country risk analysis processes. We now present an example that illustrates how Citibank structures a deal that mitigates the risks associated with the transaction while satisfying the financing needs of the customer. (This example also introduces the concept of risk transfer which we discuss in the next unit.)

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Example: Situation

Suppose a US exporter bids for the sale of $10 million of capital equipment to a buyer in a developing country. The exporter recognizes that, as in many international bidding situations, the terms of the accompanying financing proposal are a key factor in the final bid selection. Since the exporter is unwilling to finance the purchase for reasons of both liquidity and credit exposure, it turns to Citibank to provide a complete financing package.

Risk analysis

In this case, financing of the overseas buyer represents mediumor long-term commercial and country risk. In an attempt to reduce or eliminate these risks, Citibank may: n

Provide a buyer’s credit and cover portions of the risk through insurance or ECA guarantees which then make the asset more attractive for Citibank to retain

n

Purchase the draft or promissory note from the exporter and sell it through the forfaiting market at a discount that reflects the current market assessment of the underlying risk

n

Provide some combination of the above two options

Risk coverage options, however, often leave residual risks which may include:

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n

Shortfalls of principal and/or interest coverage in various insurance and guarantee programs

n

Non-coverage of principal and interest for the 15% of the contract value which is usually required as a downpayment

n

Possible exporter retention / recourse

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Option One — Buyer’s Credit Combined with Insurance or ECA Guarantee Assumption

Citibank’s in-country branch will take the commercial risk of the buyer and/or allocate cross-border facilities for a portion of the contract value / purchase price. The branch, however, wants to leverage its limited cross-border availability.

Solution

Citibank obtains a guarantee from the Export-Import Bank of the United States (EXIMBANK) covering 100% of the country and commercial risk of non-payment on 85% of the contract value of the equipment. The buyer, however, requires financing for the full purchase price. Citibank’s ability to allocate cross-border exposure, as well as commercial risk to cover the 15% down payment, gives the US exporter a competitive advantage in its bid to supply equipment to the buyer. If the branch is unable to allocate 100% of the cross-border exposure, but can approve the commercial risk, Citibank may cover the 15% down payment portion with CITI insurance. Option Two — Forfait Market

Assumption

Citibank’s in-country branch is unable to assume the commercial risk and is unwilling to make a cross-border allocation available.

Solution

After combining: (a) an EXIMBANK guarantee for the commercial and country risk that covers 85% of the contract value, with (b) local bank guarantee covering the 15% downpayment, Citibank works with a forfaiter to sell the combined EXIMBANK and “clean-risk” asset through established distribution channels. Funds paid to the exporter may be discounted based on investor-required returns and the nominal interest rate on the notes.

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Frequently, exporters will increase the contract price to the buyer to compensate for receiving any discounted proceeds. If, however, the returns required by investors make the all-in cost of purchasing the equipment too expensive for the buyer, the exporter may be willing to subsidize this return or retain a nominal risk exposure in order to secure the commercial contract. Summary In Unit 2, we discussed payment options and the documents needed for international trade transactions. In the “Commercial Financing” section of this unit, we examined two trade financing products — banker’s acceptance and forfaiting. Then, in this section, we looked at the specific structures available for export financing through ECAs, MLAs, and private insurers. All of these banking activities often require the cooperation of more than one bank. In the next section, we further describe how banks cooperate to provide trade financing to their customers. We examine the unique working relationship among banks as well as three trade products that require a correspondent banking relationship.

CORRESPONDENT BANKING Service the needs of global customers

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While banking is a highly competitive industry, members of the banking community are active customers of one another and often assist each other with different aspects of their business. If a bank does not have branches in countries where its customers conduct business, it arranges with banks in those countries to service the foreign needs of its customers.

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Relationship Among Banks A bank that performs banking services for another bank is known as a correspondent bank. Services performed by correspondent banks (including the transfer of funds, trade transactions, financing, and perhaps an account relationship) provide the foundation for international banking. Banks initiating a correspondent relationship must agree to the terms and conditions that will apply to transactions conducted between them. The banks must exchange their signature books and test keys in order to validate the contents of future communications. (Signature books are used to verify customers’ signatures. Test keys are used to establish the authenticity of instructions from bank to bank. They generally consist of tables of numbers that are used to indicate date, currency, amount, and other information.) There are different ways a bank can provide worldwide services for its customers. Sometimes international banks seek local banks to meet their local business needs. Local banks look to the international banks to provide coverage for their offshore needs. Let’s look at some of the products that require a correspondent banking relationship. Products Citibank has developed three products to use with correspondent banks who have the capacity to approve country risk, and to some extent, commercial risk, but lack an origination capability. Each product requires working out an agreement between Citibank and the correspondent bank. The three products are: n

Letter of credit confirmation

n

Nonsovereign funding

n

Participations

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Let’s examine Citibank’s role in each of these products. Letter of Credit Confirmation Standard clause

Citibank has a standard clause which is a pre-agreement between Citibank and the confirming bank abroad. It addresses the issues of country and commercial obligation in letters of credit opened by any of its branches worldwide. The clause states that the obligations of the Citibank branch will be performed under the regulations of the country in which it is located, and the correspondent bank cannot go against Citibank NY for the fulfillment of such obligations. The clause allows the Citibank branch to operate as a typical local private bank in the country. The wording of the clause cannot be amended without prior legal counsel and country risk approvals that come from the Head Office. The clause does not apply when the correspondent bank is another Citibank branch. Nonsovereign Funding While correspondent banks may be prepared to take the country risk, they may be unable to cover the specific commercial risk of the borrowers. Citibank has developed a product to address this concern. There are two methods for nonsovereign funding. 1. In Figure 3.5, the Citibank branch borrows from an (offshore) correspondent bank and lends to a local importer or exporter (borrower). The branch issues a financing agreement with a disbursement request. The borrower signs a promissory note in favor of the local branch. Assets and liabilities are registered on the local books.

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(Offshore) Correspondent Bank Country A Country B

Borrows Citibank Branch

Lends

Importer / Exporter (Borrower)

Signs promissory note Figure 3.5: Transaction recorded on the local books

2. In Figure 3.6, the Citibank branch uses an offshore booking center, such as the IBF, to book its import / export financings. The correspondent bank deposits the funds in the offshore booking center account and acknowledges that the funds will be lent directly to the importer / exporter. There is a disbursement request and a promissory note signed by the obligor (borrower) to the offshore booking center that is acting as the lender. With this method, all entries are done at the offshore unit level. Because the local Citibank branch is not legally involved in the transaction, the transaction is not recorded on the local books. Correspondent Bank

Deposits OFFSHORE Booking Center

Country A

Lends

Signs promissory note

Country B Importer / Exporter (Borrower)

Citibank Branch

Figure 3.6: Transaction not recorded on the local books

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Nonsovereign funding risks

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For both methods, the correspondent bank assumes: (1) the country risk of the country of the Citibank branch or the borrower and (2) the Citibank N.A. commercial risk. A copy of the standard financing agreements, and further details on these procedures, may be obtained from the product specialists or the managers involved with country risk. Participations

Silent / nonsilent

Correspondent banks may be prepared to take a certain percentage of Citibank’s exposure to the country and commercial risk of the borrower. The participation may be silent if the borrower has not been informed of the action. If the lender informs the borrower that the correspondent bank is taking a percentage of the exposure, then the participation is nonsilent or open. The difference between a participation and a discount, sale, or forfait finance of the note is that, with participation, the branch remains the original lender; however, the amount of exposure is reduced. Even if the correspondent bank’s participation is 100%, the lender remains the same and all communications and negotiations are done with the original lender (branch). The participation may include a:

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n

Percentage of country risk (political, convertibility, and transfer)

n

Percentage of commercial risk

n

Combination of both risks

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There is an alternative that applies only to country exposure. The correspondent bank agrees to pay the full amount of the obligation at its maturity only if the lender (Citibank) cannot collect because of a country risk event. In this situation, the document signed is an “unfunded participation agreement” that operates like an insurance policy. The “insured party” pays a fee to the correspondent for such coverage and funds the lending alone. It is very important to analyze the risk of the correspondent bank. Citibank has defined that only “AA” correspondents may be used for this alternative and a credit approval must be received from the correspondent bank’s Citibank credit control unit.

UNIT SUMMARY In the beginning of this unit, you learned important factors on which the Bank bases decisions to extend credit to customers, as well as the types of rates, terms, and conditions that may be applied to a credit extension. We then examined four purposes for trade financing. Next, you were introduced to two trade financing products — banker’s acceptance and forfaiting. We also discussed the relationships that banks maintain with other banks, with ECAs, MLAs, and with private insurance providers to facilitate export financing and other international trade transactions. Depending on the risks involved and the nature of the transaction, banks may require the support of ECAs in the form of insurance, subsidies, and/or guarantees for buyers’ or suppliers’ credit financing. ECAs provide deposit / relending, discounting, and interest rate makeup programs to commercial banks, as well as lend directly to importers and exporters. MLA financing is often associated with long-term financing for

projects that bring economic value to the importer’s country.

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Private insurance often covers the commercial and country risks for export financing transactions which are not insured by ECAs, MLAs, or other government entities. Correspondent banking is a relationship among banks that is often required for international trade transactions. Three trade products that involve correspondent banking were identified: 1) letter of credit confirmation, 2) nonsovereign funding, and 3) participations.

You have completed Unit 3: Trade Finance. Please complete Progress Check 3.3 to test your understanding of the concepts and check your answers with the Answer Key. If you answer any questions incorrectly, please reread the corresponding text to clarify your understanding and then continue to Unit 4: Risk and Compliance.

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PROGRESS CHECK 3.3

Directions: Determine the one correct answer to each question unless directed otherwise. Check your answers with the Answer Key on the next page. Question 1: Place a T in front of the statements which are true and an F in front of the statements which are false. _____ Direct extensions of credit to exporters are granted only by importers. _____ A small exporter’s best option for securing short-term pre-export financing is a commercial lender. _____ Bankers’ acceptances are the instruments used by suppliers to offer ECA-supported financing to buyers. _____ In a buyer’s credit financing, Citibank lends directly to the buyer. _____ Commercial banks may receive interest-rate subsidies from export credit agencies for specific export contracts. _____ In a buyer’s credit financing, the buyer is assigned the rights to the ECA’s insurance policy. _____ Export credit agencies compensate commercial banks for preferential fixed rate financings for certain export contracts. _____ A country’s export credit agency may focus on short-, medium-, or longterm contracts to promote the exporting sector of its country. _____ Multilateral agencies focus on short-term contracts that promote the exporting sector of developed economies. Question 2: A US exporter provides financing, insured by EXIMBANK, to an importer in a Latin American country. The exporter sells the buyer’s promissory note and assigns the insurance policy rights to Citibank in exchange for immediate payment. The buyer repays the principal and interest to: _____ a) the supplier. _____ b) EXIMBANK. _____ c) Citibank.

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ANSWER KEY

Question 1: Place a T in front of the statements which are true and an F in front of the statements which are false. F

Direct extensions of credit to exporters are granted only by importers.

T

A small exporter’s best option for securing short-term pre-export financing is a commercial lender.

F

Banker’s acceptances are the instruments used by suppliers to offer ECAsupported financing to buyers.

T

In a buyer’s credit financing, Citibank lends directly to the buyer.

T

Commercial banks may receive interest-rate subsidies from export credit agencies for specific export contracts.

F

In a buyer’s credit financing, the buyer is assigned the rights to the ECA’s insurance policy.

T

Export credit agencies compensate commercial banks for preferential fixed rate financings for certain export contracts.

T

A country’s export credit agency may focus on short-, medium-, or longterm contracts to promote the exporting sector of its country.

F

Multilateral agencies focus on short-term contracts that promote the exporting sector of developed economies.

Question 2: A US exporter provides financing, insured by EXIMBANK, to an importer in a Latin American country. The exporter sells the buyer’s promissory note and assigns the insurance policy rights to Citibank in exchange for immediate payment. The buyer repays the principal and interest to: c) Citibank.

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Question 3: In a buyer’s credit financing, the financing terms are negotiated by the: _____ a) buyer and seller. _____ b) buyer, buyer’s bank, and MLA. _____ c) buyer and buyer’s bank. _____ d) buyer and ECA.

Question 4: Export Financing for a USD 250,000 sale of US computer parts to an importer in a developing country is most likely to involve a(n): (Select all that apply). _____ a) buyer’s credit financing. _____ b) EXIMBANK insurance. _____ c) line of credit from Lloyds of London. _____ d) discounted purchase by a forfaiter of a bill of exchange drawn on the exporter, due to mature in 30 days. _____ e) banker’s acceptance.

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TRADE FINANCE

ANSWER KEY

Question 3: In a buyer’s credit financing, the financing terms are negotiated by the: c) buyer and buyer’s bank.

Question 4: Export Financing for a USD 250,000 sale of US computer parts to an importer in a developing country is most likely to involve a(n): (Select all that apply.) a) buyer’s credit financing. b) EXIMBANK insurance. e) banker’s acceptance

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Question 5: In a trade transaction that involves payment by confirmed letter of credit, the issuing bank, confirming bank, and paying bank are most likely to be: _____ a) insured by an export credit agency. _____ b) correspondent banks. _____ c) discounting trade receivables with EXIMBANK. _____ d) sharing a percentage of the acceptance commission rate.

Question 6: ECAs offer interest rate make-ups to facilitate import financing by: _____ a) compensating lending banks for the difference between market floating interest rates and preferential fixed interest rates. _____ b) allowing banks to sell promissory notes to an ECA at an appropriate discount rate. _____ c) providing a pool of attractive fixed-rate funds. _____ d) guaranteeing the debt instrument(s) of the borrower.

Question 7: Match the name of the export credit agency with the country it represents. (A country may be represented by one or more agencies.) _____J-EXIM

a) Italy

_____ECGD

b) United States

_____COFACE

c) Germany

_____SACE

d) Japan

_____EXIMBANK

e) United Kingdom

_____HERMES

f) France

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TRADE FINANCE

ANSWER KEY

Question 5: In a trade transaction that involves payment by confirmed letter of credit, the issuing bank, confirming bank, and paying bank are most likely to be: b) correspondent banks.

Question 6: ECAs offer interest rate make-ups to facilitate import financing by: a) compensating lending banks for the difference between market floating interest rates and preferential fixed interest rates.

Question 7: Match the name of the export credit agency with the country it represents. (A country may be represented by one or more agencies.) d

J-EXIM

a) Italy

e

ECGD

b) United States

f

COFACE

c) Germany

a

SACE

d) Japan

b

EXIMBANK

e) United Kingdom

c

HERMES

f) France

d

MITI

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Question 8: The correspondent banking system consists of: _____ a) local banks that provide funding to each other. _____ b) banks that provide guarantees and assume risks for their branches in other countries. _____ c) banks that perform services for other banks. _____ d) on-line test keys that are used to verify customers’ signatures.

Question 9: Place an X in front of the products that are commonly used in correspondent banking. ______Confirmation of letters of credit ______Open account ______Participations ______Nonsovereign funding ______Forfaiting ______Cash in advance transaction

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TRADE FINANCE

ANSWER KEY

Question 8: The correspondent banking system consists of: c) banks that perform services for other banks.

Question 9: Place an X in front of the products that are commonly used in correspondent banking. X

Confirmation of letters of credit Open account

X

Participations

X

Nonsovereign funding Forfaiting Cash in advance transaction

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Unit 4


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UNIT 4: RISK AND COMPLIANCE

INTRODUCTION Two particularly important considerations in international trade are the inherent risks in this type of business and compliance with international rules, regulations, and laws. In this unit, we identify the different risks that affect trade transactions, describe how Citibank manages risk, and present the US rules, regulations, and laws requiring compliance. Insurance programs that provide protection from the risks inherent in international trade also are explained. The informed banker understands these elements, how they affect international trade, and how to provide the safest and most appropriate trade products to the customer.

UNIT OBJECTIVES Upon completing Unit 4, you will be able to:

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Identify the risks for Citibank in trade transactions

n

Recognize methods that Citibank uses to manage and transfer risk

n

Recognize legal and regulatory obligations to which Citibank must conform

n

Understand the application of US sanctions, US anti-boycott regulations, US export controls, and anti-money laundering regulations

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RISKS FOR THE BANK When trade is conducted between countries, a range of risks can affect the success of the transaction. For example, changes in economic or political conditions may affect the repayment of a loan. In Units 2 and 3, we mentioned some of the risks associated with trade services and trade finance. In this section, we will define, in more detail, the credit, country, and other risks associated with international trade (Figure 4.1).

CREDIT RISK

COUNTRY RISK*

Lending

Direct Contingent

OTHER RISK

Political

Image

Convertibility

Product

Transfer

Operational / Systems Legal and Regulatory

Counterparty

Documentation Presettlement

Performance

Settlement

Figure 4.1: Categories of trade-related risk

* NOTE:

According to the Citicorp Core Credit Policy (C.C.C.P.) (revised June, 1997), Convertibility Risk and Transfer Risk are both known as CrossBorder Risk.

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Credit Risk Customerrelated risk

Credit risk (also known as commercial risk) is a customer-related risk that reflects the customer’s ability to fulfill all obligations to the Bank. (An obligation is the responsibility to pay a sum of money or perform some act when due.) The possibility that a borrower may be unable to repay a loan on time or in full, resulting in a financial loss for the Bank, constitutes a credit risk. Credit risk for the Bank falls into two categories: lending and counterparty.

Lending Risk Lending risk involves extensions of credit and/or credit-sensitive products (loans and overdrafts) where the Bank takes the full risk for the entire life of the transaction. The two types of lending risk are direct and contingent. Not settled on time

Direct lending risk is the possibility that customer obligations will not be settled on time. Direct lending risk occurs in products such as loans, overdrafts, credit cards, and residential mortgages. One trade product that incurs direct lending risk is bankers’ acceptances. The risk exists for the entire life of the transaction.

Potential obligations become actual obligations

Contingent lending risk is the possibility that potential customer obligations will become actual obligations and will not be settled on time. Contingent lending risk occurs in such products as letters of credit and confirmations of letters of credit. Counterparty Risk A counterparty is a customer with whom the Bank has a contract to simultaneously pay agreed values at a stated future date. The risk that a counterparty may default occurs either before the settlement date or at maturity of the contract.

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Default before settlement date

RISK AND COMPLIANCE

Presettlement risk (PSR) is the risk that a counterparty with whom the Bank trades may default on a contractual obligation to the Bank before the settlement date of the contract. Two conditions are required for the Bank to recognize a loss on a contract: n

Counterparty defaults (or declares bankruptcy)

n

Contract has positive market value to the Bank

Presettlement risk is measured in terms of the potential replacement cost — the potential economic consequences to the Bank — if a defaulted contract has to be replaced. Default on settlement date

Settlement risk occurs on the maturity date when the Bank simultaneously exchanges funds with a counterparty but cannot verify that payment has been received until after the Bank’s side of the transaction has been delivered. In today’s international banking environment, the different time zones between countries make it difficult to achieve a simultaneous exchange between counterparties. If the Bank delivers its side of the transaction, but does not receive delivery, it is exposed to direct lending risk. In this situation, at least 100% of the principal is at risk. The risk may be larger than 100% if there has been an adverse price fluctuation for the Bank between the contract price and the market price.

Country (Political and Cross-Border) Risk In addition to customer-related credit risk, the particular country / countries involved in an international trade transaction present risks to the Bank.

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Political or economic instability

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Country risk is the possibility that the country in which the Bank has business dealings may experience internal instability that reduces the offshore lender’s ability to collect in a timely manner. Economic problems, political disturbances, or sovereign actions within a country may make it impossible to get money or physical assets out of that country. In some cases, it may become impossible to convert local currency into a foreign currency. Country risk includes political (sovereign) and cross-border (transfer and convertibility) risk.

Political (Sovereign) Risk Government actions or independent events

Political (sovereign) risk is the possibility that the actions of a sovereign government (e.g., confiscation, expropriation or nationalization) or independent events (e.g., wars, riots, civil disturbances) affect the ability of customers in that country to meet their obligations to Citibank. Political risks are most significant in transactions between a developed and an emerging-market country.

Transfer Risk Inability to move funds

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Transfer risk exists in any transaction in which the borrower may be unable, due to legal or other barriers, to transfer funds in the foreign currency of payment to the place of payment when its obligation in that currency matures.

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Convertibility Risk Inability to exchange local currency for foreign currency

Convertibility risk exists in any transaction in which legal or regulatory barriers may prevent the borrower from converting his/ her local currency into the foreign currency required for payment when the obligation in that currency matures. Convertibility risk is inherent in any transaction that requires a flow of funds through an exchange control barrier such as a country’s central bank. This risk does not refer to devaluation of currency; rather, it reflects the risk that the local currency will be inconvertible. Less-developed countries usually are short of hard currencies. Therefore, an importer may experience delays or an inability to convert the local currency to the currency of the exporter for payment.

Example

For example, let’s say that Egypt has accumulated French Francs locally as a result of a prior trade transaction and wants to use these funds to pay a multinational construction company for a local construction project. Although the deal is denominated in French Francs, a liquid currency which can be hedged, an Egyptian bank involved in the transaction runs the risk associated with its responsibility for getting the money out of Egypt. (The Egyptian government may create a transfer risk situation if the government prohibits the transfer of French Francs out of the country.) Note that when an overseas branch of Citibank does business in that country, there is no convertibility risk if the trade finance is funded locally (e.g., use of hard currency from local deposits). There would have been cross-border risk if the transaction had been funded offshore (e.g., a loan from an International Banking Facility to the branch).

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Other Risks Credit and country risk are the two primary risks the Bank deals with in international trade transactions. Other risks that must be considered include image, product, operational / systems, legal and regulatory, documentation, and performance risk. Image Risk Damage to the Bank’s reputation

Image risk is the possibility that some activity of the Bank or one of its representatives damages the reputation of Citibank. One way to protect the Bank is to maintain confidentiality at all times! In addition, Citibank avoids financing products or services, such as medicines and weapons, that may damage the Bank’s reputation. Trade products that may produce image risk include letters of credit, bankers’ acceptances, documentary collections, and bank-to-bank reimbursements. Bank-to-bank reimbursement is a trade product that is used when the letter of credit transaction between the applicant and beneficiary from different countries is denominated in a third-country currency, usually US dollars. The reimbursing bank pays the advising / negotiating bank in the currency stated in the letter of credit and based on the reimbursement authorization issued by the issuing / opening bank. The reimbursing bank charges a fixed fee to either the issuing / opening bank or the beneficiary and represents a valuable source of income for Citibank. Product Risk

Faulty or inadequate trade product or service

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Product risk is the risk that the structure of a certain trade product or service is inadequate or faulty. Letters of credit, bankers’ acceptances, documentary collections, and bank-to-bank reimbursements are trade products that have this risk. Guidelines and quality standards for handling trade transactions help alleviate product risk.

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Operational / Systems Risk Failure of internal / external processing systems

Operational / systems risk refers to risks associated with the functional aspects of the products. This risk is high in trade transactions due to reliance on the manual examination of documents and bills and the use of technology.

Example

Operational / systems risk may be internal or external to the Bank. For instance, in a money transfer system there is a risk associated with an external system. When the Bank transfers funds by wire, it may use private international communications systems such as the Society for Worldwide International Financial Telecommunications (SWIFT). There is always a risk that a disruption of services may prevent or delay the transfer. Legal and Regulatory Risk

Noncompliance with regulations

Many legal and regulatory factors affect trade transactions. These include foreign currency laws, local legal lending limits, US sanctions, and US anti-boycott regulations and taxes. (We look at some of these compliance issues later in this unit.) When a transaction does not comply with all applicable laws and regulations, the Bank may face civil, criminal, and administrative proceedings. Trade products that carry legal and regulatory risk include: letters of credit, bankers’ acceptances, documentary collections, and bank-tobank reimbursements. Documentation Risk

Incorrect or unenforceable documentation

Written instruments such as legal forms, receipts, and applications are required to enforce the Bank’s rights under contracts or transactions. Documentation risk is the possibility that these instruments are incorrect, incomplete, or unenforceable.

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Performance Risk Failure of exporter to perform

Performance risk is the possibility that an exporter may fail to perform under the contract established with the importer. For example, if an exporter does not deliver critical parts or sends unacceptable parts, the importing manufacturer may be unable to produce his or her final product. The exporter’s performance failure affects the importer’s ability to generate cash from the sale of goods and repay his or her obligation to Citibank.

Risks in a Trade Finance Transaction You have read about the risks associated with trade transactions. As you continue with the following example of a simple trade finance transaction, try to identify some of the risks Citibank will incur. Example

An exporter in Italy receives an advance payment of US $7MM from Citibank, New York, for goods that will be shipped to a US importer beginning in nine months. The US importer agrees to pay the principal amount in US dollars to Citibank, NY upon receipt of the shipments. The exporter agrees to pay the interest by converting Italian Lira into US dollars through the local Citibank branch, which will remit the interest payments to Citibank, NY. Shipments to the importer begin in nine months and take place over a period of two months. For each shipment received, the importer has thirty days to remit the corresponding payment to Citibank, NY. In the meantime, the exporter pays Citibank, NY, 10% per annum interest on the balance due. This rate is a function of the risks associated with the transaction and the cost of mitigating the risks. For Citibank, the risks associated with this transaction are: n

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Credit Risk: Risk that the exporter is unable to produce the goods or pay the interest on the balance due and the risk that the importer refuses or is unable to pay the principal amount.

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n

Political (Sovereign) Risk: Risk that the exporter is unable to export due to local government actions such as confiscation, expropriation, or nationalization

n

Convertibility Risk: Risk that the exporter is unable to convert local currency to US dollars to pay interest on the balance due

n

Legal and Regulatory Risk: Risk that the importer is unable to clear goods through customs for import due to quotas or failed Food and Drug Administration (FDA) inspection

RISK MANAGEMENT You have seen that international business primarily involves credit and country risks. Assessing and undertaking commercial risk is the traditional role of banks and, as you learned in Unit 3, banks have established standard practices for determining the creditworthiness of customers. Banks that finance international trade also must analyze the country risk of the obligor’s country or countries involved in the transaction. In this section, we will look at the process Citibank uses to establish risk allocations for target market countries and describe some of the techniques Citibank uses to manage this risk. Allocating Cross-Border Risk Control unit

Citibank manages country risk through its branch network. The Country Senior Credit Officer (CSCO) and the branch in a country represent the control unit for that country. If there is no branch in a particular country, the nearest division office becomes the control unit. For example, Citibank Nairobi serves as the control unit for Kenya and for the other English-speaking countries in the region where there is no branch office.

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Cross-border allocations for country / region

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The CSCO is responsible for assessing the political and economic risk of the particular country or region. Based on that assessment, the CSCO proposes to the Citibank Head Office a specific crossborder allocation for the country. The CSCO’s proposal includes a: n

Suggested limit on the total amount of cross-border business which Citibank should do with that country

n

Description of the recommended type of cross-border business For example, the CSCO may recommend that the Bank confirm letters of credit from a country, but should refrain from any direct lending to the country.

n

Control unit manages limit

Recommendation for tenors attached to each type of business

Regardless of where a transaction originates, Citibank limits the amount and type of business that can be done cross border with any particular country. The local control unit in each country manages that limit. For example, if a Relationship Manager in New York has a customer who wants payment under a confirmed letter of credit for exports to Argentina, the control unit in Buenos Aires must approve the transaction. This approval process is called allocating cross border. A comparison with a standard line of credit for companies or individuals may help you understand how this allocation is managed. A company or individual has pre-established credit limits based on its financial condition. Once a company has reached its preestablished credit limits, no new transactions are possible until some portion of the line has been repaid. In the case of country risk, the limits are based on an analysis of political and economic conditions of a country, rather than on the balance sheet fundamentals of a company or individual.

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Business restricted by limits

Citibank’s ability to generate new business worldwide often strains these cross-border limits. The Bank potentially can originate more transactions with companies wanting to do business in countries with cross-border limits than it is capable of serving based on risk allocation alone.

Example

For example, the control unit in Brazil set a total cross-border limit of $600 million for 1995. This means that companies outside Brazil who wanted Citibank to participate in their Brazilian trade transaction would have been unable to use Citibank if the total of the Brazilian deals on Citibank’s books worldwide equaled $600 million. This tension between Citibank’s ability to generate new business and restrictions resulting from cross-border limits has led to the development of risk transferring techniques. In the next section, we define and illustrate the risk transfer process.

RISK TRANSFER Shift of country and/or commercial risks

Risk transfer essentially involves finding ways to shift the country (political and cross-border) and/or commercial risks of international trade. The goals of risk transfer are to (1) help our customers do business in countries which present unique opportunities and specialized potential problems and (2) earn significant fees without exceeding Citibank’s own risk constraints. Risk Transfer Through Syndication

Example: syndication

To help you understand the risk transfer process, let’s look at an example that illustrates how Citibank uses syndication to handle a deal that exceeds the cross-border limit for a country.

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A British company wants to export tea to Egypt. Due to the crossborder risk associated with the deal, the exporter wants payment under a confirmed letter of credit. Citibank is asked to confirm the letter of credit, but the amount exceeds the cross-border limit established for Egypt. Recall that syndication (discussed in Unit 3) is the process of transferring risk by splitting the risk into several parts and finding investors who want to share that risk. Without some transfer of risk, Citibank cannot effect the transaction. By bringing other investors into the transaction, Citibank is able to accept the business. In this case, Citibank asks five banks to share the cross-border risk (transfer and convertibility risk), with each taking a different percentage of the total in return for a proportionate share of the fee for providing the letter of credit. In addition, Citibank takes a fee for originating the deal and bringing it to the investors. If the issuing (Egyptian) bank defaults for political reasons, each bank pays only the portion of the letter of credit amount which it agreed to accept. Transfer of cross-border risk

Cross-border deals typically separate the credit risk from the crossborder risk of the deal. Citibank usually keeps the commercial risk and syndicates the cross-border risk. Let’s see how this works.

Silent syndications

Risk transfer syndications may be “silent” or “open.” In a silent syndication, the customer does not know that there are other investors in the transaction. Citibank accepts the risk of the entire transaction and then sells pieces of the deal to other banks. Citibank also sets the fees for the deal. Citibank bears the counterparty and documentation risk. If Citibank sells a portion of the deal to a bank which then defaults on its portion of the deal, Citibank is responsible for that amount. The advantage to Citibank is that it receives a fee for committing the funds and then sells the deal at a spread in order to retain a portion of the fees that are paid to the other banks.

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Open syndication

RISK AND COMPLIANCE

In an open syndication, the investing banks act as a consortium. The lead bank manages the transaction, but all the banks are disclosed to each other and to the customer. The customer must assess the counterparty risk of each participating bank because the customer, rather than Citibank, bears the risk. If one of the banks defaults on its obligation, the customer bears the loss. Citibank is not responsible for the whole transaction, even though it may be the lead bank that arranged for the syndicate. Investors in Risk Transfer Transactions We have already mentioned one transfer risk technique, syndication. In this section, we will examine other techniques in the context of the parties investing in risk. These parties include banks, insurance companies, export credit agencies, and other investors. Banks

Preferred investors for syndications

Banks represent about 50% of the market for risk transfer. They are the preferred investors in risk transfer transactions because they tend to evaluate deals in the same way as Citibank. Other banks also have similar documentation needs and approaches to investment. As we discussed earlier, banks invest in risk through syndications. Insurance Companies

Write policies

Like banks, insurance companies are significant investors in the risk transfer market, accounting for about 40% of the total. Insurance companies, however, differ from banks in the way they invest in risk. They invest by writing policies in which there is a beneficiary who submits a claim in the event of a default.

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For example, suppose that Citibank accepts the country risk of a deal in a less developed country and transfers that risk through an insurance policy. In the event of default for political reasons covered under the policy, Citibank will make a claim on the insurance company and receive payment. The field of trade-related insurance addresses trade credit risk as well as country risk. Trade credit risk

Trade credit insurance is used to protect receivables from a wide range of risks, including the actions of private obligors and sovereign governments. Trade credit insurance provides financial protection against political instability, regional or global economic problems, and natural disasters that may affect goods in transit.

Country risk

Country risk insurance is used to protect against losses resulting from actions or inaction of a sovereign government. Country risk insurance is not a financial guarantee since it does not cover commercial risk. For example, it may be used when cross-border exposure becomes a constraint to the trade transaction. Country risk insurance covers: n

Currency inconvertibility and/or non-transfer A government blocks conversion or transfer of currency (This is not devaluation risk.)

n

Contract frustration A government entity defaults on or blocks the deal

n

Confiscation, expropriation, nationalization (CEN) A government seizes the investment

n

Unfair calling guarantee A government unfairly calls the performance bond

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RISK AND COMPLIANCE

The insured must maintain confidentiality about the insurance. Claims are payable after a specified “waiting period.” We describe below two such insurance providers: CITI and Lloyds of London. CITI

Citicorp International Trade Indemnity, Inc. (CITI) is a Citicorp business that provides trade-related insurance (political risk, trade credit risk, and marine cargo). CITI’s customers include importers, exporters, contractors, manufacturers, financial institutions, and insurance intermediaries. Anyone who has a stake in the flow of capital and commerce across borders can benefit from the services offered by CITI.

Lloyds of London

Lloyds of London, a 300-year old association in London, originally provided marine insurance. Its members — composed of merchants, ship owners, underwriters, and brokers — underwrite policies for each other. It is the largest insurance marketplace in the world. Lloyds of London provides: n

Direct insurance (property / casualty)

n

Indirect insurance or reinsurance (country risk, transportation)

n

Catastrophe reinsurance

Export Credit Agencies (ECAs) You learned in Unit 3 that most developed countries have government agencies that promote exports, particularly exports to emerging-market countries. The export credit agencies (ECAs) use either guarantees or insurance to help the exporting company cover the commercial risk of the overseas importer and the country risk of the importer’s country.

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Typically, Citibank originates a transaction and then contacts the relevant ECA to arrange some form of risk transfer (insurance or guarantee). The ECA accepts a majority portion (but not all) of the risk and the transaction proceeds. The Bank structures these deals. One of Citibank’s strengths is its ability to interact with all of the key ECAs in order to ensure the success of these transactions. Example

Here is an example of the process. A US exporter wants to sell capital equipment to Venezuela. The exporter — a Citibank customer — requests that Citibank confirm the letter of credit for the equipment. Since Citibank does not want to accept the entire country risk (perhaps it will exceed its Venezuelan cross-border limit), Citibank requests cross-border guarantees from the US EXIMBANK. EXIMBANK issues the guarantee for 85% of the country risk, leaving Citibank with 15%. In the event of default for political reasons, Citibank will retrieve from EXIMBANK the 85% portion that has been guaranteed. The remaining 15% is Citibank’s risk. Other Investors — Forfaiting As we saw in Unit 3, forfaiting involves the sale without recourse of a cross-border receivable from an exporter. Essentially, forfaiting is a technique that transfers to investors the commercial and country risk of the overseas buyer, the obligor. The commercial risk may be mitigated somewhat by a bank guarantee on the paper (although the investor now bears the bank’s risk rather than the importer’s risk).

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RISK AND COMPLIANCE

Primary investors in the forfait market are merchant banks, forfaiting houses (specialists in trading these investments), and forfaiting departments of banks. These investment houses typically establish networks of secondary investors who reside in the country of the obligor. Because local investors often are more comfortable with their local political, transfer, and/or convertibility risks than someone from another country may be, these secondary investors are more likely to buy paper that originates locally. The importer may be able to get longer terms through forfaiting than with other forms of finance, because forfaiting transfers risk to secondary investors who find the risk of a particular country attractive. Example of Risk Transfer / Risk Management Let’s examine a situation where Citibank satisfies a customer’s export financing needs while maintaining an acceptable risk exposure. Export Finance: Short term

Suppose a US supplier (exporter) has a US$15 million contract to sell products to a government-owned buyer in a developing country whose import regulations require that foreign suppliers grant 360day terms. The US exporter, however, is unwilling to take the risk of possible non-payment of the resulting trade receivables.

Risk analysis

In this situation there is the country risk associated with the overseas government which may delay payment at maturity. There is also the commercial risk that the buyer will default because the obligations of the government-owned entity are not, in this situation, backed by the full faith and credit of the country. There are three ways that Citibank may satisfy the financing needs of the exporter.

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Option One Assumption

First, let’s assume that Citibank’s in-country branch is willing to take the commercial risk of the buyer but is unable to allocate crossborder (political) exposure for the full amount of the transaction.

Solution

On behalf of Citibank’s customer (the exporter), Citibank obtains an insurance policy from EXIMBANK to cover 90 to 95 percent of the country risk. (Depending on the country, the coverage may be less than 90% or it may be unavailable.) The remaining country risk exposure could be covered through a cross-border allocation, a trade facility established through debt rescheduling, or recourse to the exporter. Retaining only an acceptable amount of risk, Citibank then purchases the discounted receivables from the exporter.

Option Two Assumption

Another option exists if the exporter is willing to grant a 360-day credit to the buyer. The exporter may be willing to take all of the commercial risk because s/he believes the buyer to be a reputable corporation in its field and can earn a return on the financing that justifies taking the risks. The exporter, however, wants to avoid political risk exposure for the full amount of the transaction.

Solution

In this case, Citibank can arrange insurance coverage through Citibank International Trade Indemnity (CITI) covering 95 percent of the country risk in the transaction. The exporter, however, must retain the remaining 5 percent exposure. Notice that Citibank is providing structuring rather than financing support and, as a result, this solution provides fee income without having to meet Return on Assets (ROA) criteria.

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Option Three Assumption / solution

Finally, let’s assume that EXIMBANK coverage is unavailable for this country or tenor. CITI coverage may be available for 95% of the country risk, but the exporter wants to eliminate country and commercial risks altogether. Citibank’s in-country branch is willing to assume commercial risk for the entire transaction and has cross-border capacity to cover the remaining five percent of the country risk. You have been introduced to the types and goals of risk transfer. We conclude this section with a discussion of its advantages. Advantages of Risk Transfer Risk transfer provides three primary advantages to Citibank. 1. Increased market share and risk capacity

Example

For example, Brazil’s cross-border limit in 1995 of $600 million was insufficient to meet the demand of Citibank customers who wanted protection from the country risks associated with Brazilian trade. Through risk transfer techniques such as syndication, Citibank was able to do twice the amount of business it could have transacted, given the $600 million limit. In this case, the total portfolio of Brazilian deals which Citibank originated in the first quarter of 1995 was $1.2 billion. 2. Building a positive image and reputation in a particular market

Example

Syndications, especially silent syndications, allow Citibank to arrange very large transactions that bolster the Bank’s reputation and lead to other originations. An example is a very large capital project costing several hundred million dollars and lasting a number of years. In such a case, Citibank transfers both the country and commercial risk in order to arrange deals where the amount of risk is beyond the capacity of any one bank.

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3. Leveraged returns Example

An example helps illustrate the advantage of leveraged returns. Kenyan risk is generally priced in the market at about 4% per annum. If Citibank keeps all of a deal involving Kenya, the Bank earns a 4% return on the country risk. By transferring some of the risk, the Bank earns 4% on the retained portion, management and advisory fees, and the “skim” that represents the difference between the fees paid by the customer and the amount paid to the syndicate members. The total revenue, as a is much greater than the 4% the Bank would have earned by booking the entire amount. (In order to earn the skim, the syndication must be silent, which is true of most deals.) Risk transfer also helps Citibank reduce the assets carried on its balance sheet. Booking assets is not very attractive because it is difficult to generate sufficient returns on those assets. (Expected return on assets is discussed in Unit 5.)

SUMMARY In this section, we defined credit risk and identified its subcategories, lending risk (direct and contingent) and counterparty risk (presettlement and settlement), which are commonly associated with a trade transaction. We also identified several other risks associated with trade transactions. The more common risks fall under the category of country risk which includes political (sovereign) and cross-border (transfer and convertibility) risks. Other risks to consider are image, product, operational / systems, legal and regulatory, documentation, and performance risks.

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Citibank assigns the Country Senior Credit Officer (CSCO) the responsibility for evaluating country risk and establishing the crossborder allocation for that country. Through bank syndication, insurance policies, export credit agency guarantees, and forfaiting, Citibank transfers risk to other investors and, therefore, improves its balance sheet and market position relative to its risk limits. You have completed the first section of Risk and Compliance. Please complete Progress Check 4.1, then continue with the next section on “Compliance Issues.” If you answer any questions incorrectly, please review the appropriate text.

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PROGRESS CHECK 4.1


Question 1: Match each trade-related risk with its corresponding example. a) Credit risk

e) Operational / systems risk

b) Image risk

f) Documentation risk

c) Performance risk

g) Transfer risk

d) Political (sovereign) risk _____ In the process of granting a loan to a company, the Bank requests a signature on the promissory note. The person who signs the document is unauthorized by the company to do so and the note becomes unenforceable. _____ A customer of the Bank develops financial difficulties and is unable to repay a loan from the Bank at the specified date. _____ A potential customer requests financing for a project to develop a new type of assault weapon. _____ Telecommunications in the northeast part of the United States have been disrupted, making it impossible to transfer funds electronically. _____ The buyer’s country has experienced civil disturbances that affect the buyer’s ability to meet his/her obligations to the Bank. _____ A swimsuit manufacturer receives defective fabric from an overseas supplier and is unable to produce swimsuits in time for the summer season. _____ Due to a shortage of dollars in the Egyptian central bank, an Egyptian importer is unable to pay the US supplier in US dollars as specified by the contract.

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ANSWER KEY

Question 1: Match each trade-related risk with its corresponding example. a) Credit risk

e) Operational / systems risk

b) Image risk

f)

c) Performance risk

g) Transfer risk

Documentation risk

d) Political (sovereign) risk f

In the process of granting a loan to a company, the Bank requests a signature on the promissory note. The person who signs the document is unauthorized by the company to do so and the note becomes unenforceable.

a

A customer of the Bank develops financial difficulties and is unable to repay a loan from the Bank at the specified date.

b

A potential customer requests financing for a project to develop a new type of assault weapon.

e

Telecommunications in the northeast part of the United States have been disrupted, making it impossible to transfer funds electronically.

d

The buyer’s country has experienced civil disturbances that affect the buyer’s ability to meet his / her obligations to the Bank.

c

A swimsuit manufacturer receives defective fabric from an overseas supplier and is unable to produce swimsuits in time for the summer season.

g

Due to a shortage of dollars in the Egyptian central bank, an Egyptian importer is unable to pay the US supplier in US dollars as specified by the contract.

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Question 2: Citibank’s exposure to cross-border risk is managed by: _____ a) the Head Office. _____ b) each Country Senior Credit Officer in its branch network. _____ c) product managers. _____ d) the Society for Worldwide International Telecommunications.

Question 3: Investors willing to share the political risk of a Citibank syndication are helping the bank reduce its exposure to: _____ a) credit risk. _____ b) regulatory risk. _____ c) country risk. _____ d) commercial risk.

Question 4: Guarantees are a risk transfer technique provided to Citibank by: _____ a) export credit agencies. _____ b) insurance companies. _____ c) Citicorp International Trade Indemnity, Inc. _____ d) Lloyds of London.

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ANSWER KEY

Question 2: Citibank’s exposure to cross-border risk is managed by: b) each Country Senior Credit Officer in its branch network.

Question 3: Investors willing to share the political risk of a Citibank syndication are helping the bank reduce its exposure to: c) country risk.

Question 4: Guarantees are a risk transfer technique provided to Citibank by: a) export credit agencies.

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Question 5: Place an X on the line in front of the types of credit risk. _____ Political risk _____ Direct lending risk _____ Transfer risk _____ Legal and regulatory risk _____ Contingent lending risk

Question 6: The types of risks found in a trade transaction are defined below. Write the risk category beside its definition. Be as specific as possible and include sub-categories where appropriate. __________ The actions of a government or independent events may affect the ability of a customer of the Bank to meet his or her obligations to the Bank. __________ The possibility that an activity of the Bank or one of its representatives may damage the reputation of the Bank. __________ One of the written instruments necessary for the trade transaction may be incomplete, incorrect, or unenforceable. __________ The chance that a possible customer obligation will become an actual obligation and will not be settled on time. __________ The probability that a country’s central bank will not allow a flow of funds out of the country to complete the transaction. __________ The risk that a transaction does not comply with all relevant regulations.

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ANSWER KEY

Question 5: Place an X on the line in front of the types of credit risk. Political risk X

Direct lending risk Transfer risk Legal and regulatory risk

X

Contingent lending risk

Question 6: The types of risks found in a trade transaction are defined below. Write the risk category beside its definition. Be as specific as possible and include sub-categories where appropriate. Political (sovereign)

The actions of a government or independent events may affect the ability of a customer of the Bank to meet his or her obligations to the Bank.

Image

The possibility that an activity of the Bank or one of its representatives may damage the reputation of the Bank.

Documentation

One of the written instruments necessary for the trade transaction may be incomplete, incorrect, or unenforceable.

Lending (contingent lending)

The chance that a possible customer obligation will become an actual obligation and will not be settled on time.

Transfer (cross-border)

The probability that a country’s central bank will not allow a flow of funds out of the country to complete the transaction.

Legal (regulatory) risk

The risk that a transaction does not comply with all relevant regulations.

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Question 7: Place a T in front of the true statements and an F in front of the false statements. _____ a) “Country risk” is the possibility that a borrower may not be able to repay a loan on time. _____ b) “Lending risk” is a type of credit risk. _____ c) “Product risk” is the risk that imported products may be defective. _____ d) “Documentation risk” is the risk that documents required to complete the trade transaction are incorrect. _____ e) “Country risk” includes political and transfer risk.

Question 8: Political risks are most significant in transactions between companies in: _____ a) two developed countries. _____ b) countries with freely convertible currencies. _____ c) a developed and an emerging-market country. _____ d) countries with local legal lending limits.

Question 9: The descriptions of two risk transfer techniques are found below. Write the name of the risk transfer technique beside its description. _______________

The risk of a transaction is split into several parts and shared by investors willing to accept a portion of the risk in return for a portion of the fee.

_______________

Risk is transferred to overseas investors who purchase exporters’ receivables without recourse.

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ANSWER KEY

Question 7: Place a T in front of the true statements and an F in front of the false statements. F a) “Country risk” is the possibility that a borrower may not be able to repay a loan on time. (This is credit risk.) T b) “Lending risk” is a type of credit risk. F c) “Product risk” is the risk that imported products may be defective. (Product risk happens when the structure of a certain trade product is faulty or inadequate) T d) “Documentation risk” is the risk that documents required to complete the trade transaction are incorrect. T e) “Country risk” includes political and transfer risk.

Question 8: Political risks are most significant in transactions between companies in: c) a developed and an emerging-market country.

Question 9: The descriptions of two risk transfer techniques are found below. Write the name of the risk transfer technique beside its description. Syndication

Forfaiting (other investors)

The risk of a transaction is split into several parts and shared by investors willing to accept a portion of the risk in return for a portion of the fee. Risk is transferred to overseas investors who purchase exporters’ receivables without recourse.

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Question 10: Risk transfer enables Citibank to finance transactions that: _____ a) do not conform to US legal requirements. _____ b) do not meet the Bank’s credit criteria. _____ c) cannot be sold in the forfait markets. _____ d) exceed the total cross-border allocation for a particular country.

Question 11: Identify three parties that are able to provide insurance against political risks associated with international trade transactions. _____ a) Citicorp International Trade Indemnity, Inc. (CITI) _____ b) Citibank, Nairobi _____ c) Lloyds of London _____ d) Export Import Bank of the United States (EXIMBANK) _____ e) SWIFT _____ f) Citibank, New York

Question 12: The purpose of Citibank’s cross-border risk allocation is to: _____ a) limit the amount and type of international business that can be done with any country. _____ b) transfer a portion of the risk to other investors. _____ c) ensure that the risk is acceptable in forfait markets. _____ d) earn a portion of fees paid to syndicate banks.

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ANSWER KEY

Question 10: Risk transfer enables Citibank to finance transactions that: d) exceed the total cross-border allocation for a particular country. Question 11: Identify three parties that are able to provide insurance against political risks associated with international trade transactions. a) Citicorp International Trade Indemnity, Inc. (CITI) c) Lloyds of London d) Export Import Bank of the United States (EXIMBANK)

Question 12: The purpose of Citibank’s cross-border risk allocation is to: a) limit the amount and type of international business that can be done with any country.

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COMPLIANCE ISSUES We mentioned earlier that one of the risks inherent in international trade stems from the need to comply with legal and regulatory requirements. Conforming to a rule or demand

In general terms, compliance is the act of conforming to a rule or demand. At Citibank, we must conform not only to high ethical standards, but to legal and regulatory obligations in the United States and other countries. These rules and regulations include: n

Statutes and regulations adopted by a governmental regulatory body

n

Decrees and orders written by any court that has authority over a Citicorp business or entity

n

Ethical standards described in the Citicorp Policy Manual

Compliance issues in the trade business include US sanctions, US anti-boycott regulations, US export controls, and rules concerning anti-money laundering activities. (We examine each of these in the pages that follow.) Different Bank activities are concerned with different compliance issues.

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n

In the Transaction Services area, specifically in Trade, Citibank employees need to know about US sanctions, US anti-boycott rules, US export controls, and rules concerning anti-money laundering activities.

n

In the Cash Management area, an awareness of rules concerning anti-money laundering activities is required.

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Responsibility of each Citibank employee

Compliance is a personal responsibility. Each Citibank employee is held accountable for all compliance-related activities; s/he must be familiar with the rules, regulations, and ethical standards related to his or her assignment. Each Citibank employee is provided with the appropriate level of compliance training specific to his/her job assignment and must follow the requirements stated in his/her group’s compliance program.

Conflict of law issues

When a conflict of law issue occurs, it is important to analyze and deal with it quickly. Accounts and assets located outside the United States are subject to local governmental laws and regulations. Both US laws and local laws must be obeyed, but sometimes these two sets of laws conflict.

Example

For example, when local laws permit (or require) normal trading and financial relations with countries (or individuals) that are subject to US sanctions, conflicts of law occur. When such a controversy or conflict occurs, it is necessary to seek help from a supervisor. If the problem cannot be resolved, the compliance officers and legal counsel should be consulted. Remember, Citibank’s policy is to comply with US law and local laws. If a conflict between US law and local laws occurs, a satisfactory solution must be found. Let us now look at four trade business compliance issues: sanctions, anti-boycott laws and regulations, export controls, and anti-money laundering laws and precautions. US Sanctions

Blocking of a government’s assets

A sanction is an economic measure adopted by one or several countries to force a nation that is violating international law to discontinue the offending behavior. Sanctions generally require a freeze or blocking of the sanctioned government’s assets. Trade with the country is also prohibited. Sanctions may affect the following trade products: letters of credit, documentary collections, bankers’ acceptances, and bank-to-bank reimbursements.

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The United States government occasionally adopts sanctions against the governments of certain countries — and sometimes against their citizens. These sanctions are imposed under the authority of one of the following: n

Trading with the Enemy Act

n

International Emergency Economic Powers Act

n

United Nations Participation Act

Sanction Administration in the US Sanctions are administered according to regulations issued by the US Department of Treasury’s Office of Foreign Assets Control (OFAC). OFAC lists

The Office of Foreign Assets Control publishes extensive lists of “specially designated nationals” (SDNs) — persons or companies considered to represent the governments of sanctioned countries. The OFAC also publishes a list of “specially designated terrorists” (SDTs) and of “specially designated narcotics traffickers” (SDNTs). The assets of anyone included in any of the three lists – SDNs, SDTs, and SDNTs – also must be blocked, even if they are located outside the “blocked” country. Because of the complexity of these regulations, it is important to consult with your group’s counsel or the Legal Affairs Office if a question arises concerning the assets of blocked countries or of anyone included in any of the three lists. The Compliance Officer has a list of blocked countries as well as the lists published by the OFAC on the SDNs, SDTs and SDNTs.

Blocking accounts

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Citibank must block accounts and assets if they: n

Belong to a blocked entity

n

Are going to a blocked destination

n

Are from a blocked destination

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When the blocked name is an existing customer of the Bank, the existing accounts must be blocked. All documents (checks, bills of lading, etc.) must be seized and kept as blocked items. No trade may be conducted until permission is obtained from the OFAC. Local licenses do not satisfy US law. If the blocked entity does not have an account with Citibank, a special “blocked” interest-bearing account must be created. These accounts cannot be debited without a license from the US government. However, credits can and must be made. Citibank is not allowed to return funds to the remitter. Reporting Requirements All units maintaining blocked accounts or transactions must keep complete, up-to-date records. Reports must be submitted to the OFAC at specified intervals and sometimes on demand. Reporting is usually done by Group Counsels or by the Legal Affairs Office. Penalties Civil penalties of up to $250,000 may be imposed for violation or evasion of the regulations (for example, helping a customer avoid the effect of the sanctions). If the violation or evasion is intentional, the maximum fine can be $1,000,000 and/or a prison term of up to twelve years. Severe violations may cause the loss of a franchise. US Anti-Boycott Laws and Regulations Request not to do business

A boycott is an explicit or implied request not to do business with certain persons or companies in countries that are friendly to the United States. The most well-known example is the boycott of Israel by Arab and Islamic countries. US companies are not allowed to comply with boycott requirements that have been imposed by governments, persons, or entities. The Export Administration Act (EAA) of 1977 and the Tax Reform

Act of 1976 prohibit this type of activity.

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The US anti-boycott laws and regulations apply particularly to trade situations. However, they may apply to other situations, such as the hiring process, choosing business partners, or business opportunities. Boycott request

A Citibank subsidiary may receive a boycott request. If this situation occurs, for example, in a clause of a letter of credit, Citibank should decline to participate in the transaction unless the clause is removed or satisfactorily changed. Reporting Requirements Citicorp’s participation, or request to participate, in a boycott must be reported directly to the Commerce Department. Under Section 999 of the Internal Revenue Code, boycott requests also must be reported annually with Citicorp’s federal tax return. Penalties The Export Administration Act (EAA) imposes civil fines of up to $10,000 for each violation of US anti-boycott laws and regulations. Implementing and not reporting a boycott clause equals two violations. Criminal fines are up to $50,000 or, in the case of an export transaction, five times the value of the exported goods and/or imprisonment for up to five years. In addition, export privileges or the right to finance exports may be revoked or suspended. Violation of these laws may require the payment of a penalty — which may damage the Bank’s reputation.

Discovering Noncompliance Issues To discover noncompliance with anti-boycott policies, look for the following in trade transaction-related contracts: n

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Origin of manufactured goods

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Examples of noncompliance clauses

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n

Blacklisted status of any party

n

Eligibility of a carrier vessel to enter the ports of a country or group of countries

n

Prohibited shipments on certain vessels and limitations on their routes

n

Business relationships with certain countries that request participation in a boycott

For example, letters of credit may contain a clause certifying that the goods are “not of Israeli origin” or that the vessel carrying the goods “will not stop at Israeli ports.” Citibank must go back to the bank that issued the document and negotiate a deletion or change of the offending clause. Citibank must report to the US government the original clause that was believed to be a “request” to participate in the boycott. Another example is a clause requiring “provision of a certificate stating that the vessel carrying the goods is not blacklisted.” Citibank must go back to the issuing bank and request deletion of the clause. Because this type of clause is prohibited under both the Export Administration Act of 1977 and the Tax Reform Act of 1976, reports must be filed with the US Department of Commerce and the US Department of Treasury. The proper procedures for handling non-conforming situations are explained in the Anti-Boycott Compliance Manual. You may obtain this manual from the local anti-boycott compliance officer or from the Legal Affairs Office. Anti-boycott laws apply to Citibank branches in the United States and overseas as well as Citicorp’s domestic and international subsidiaries and affiliates. We have examined the reporting requirements and penalties relating to US sanctions and US anti-boycott laws. We will now look at the third compliance issue, US export controls.

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US Export Controls High technology or strategic goods

The export of high technology or strategic goods from the United States to other countries and/or the re-export of US technology from one country to a third country are subject to US export controls for all countries. Citibank and its worldwide branches become involved when they are asked to finance the production of goods or the export of goods through a letter of credit. Examples of high technology or strategic goods are computers, airplanes, arms-related technology, some chemicals, software, and encryption devices. Citibank has to be especially cautious when US technology is re-exported from Country X to Country Y. The export control compliance process must include checking the lists of individual parties included in the following listings published by the US Department of Commerce: n

Missile Tech & Chemicals / Biological

n

Debarred Parties

n

Table of Denial List

Whenever the transactions contain names that appear on the lists, they must not be processed. The Trade Advisory Unit and the Business Unit Compliance Officer should be consulted for further guidance. It is Citibank’s policy that the Credit Policy Committee must review and approve any transaction involving the shipment of military equipment, military parts, or armaments.

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Reporting Requirements Before exporting, the exporter must obtain a validated export license for high technology or strategic goods from either the US Department of Commerce Office of Export Administration (OEA) or the US Department of State. Some licenses require reporting, but this usually is the responsibility of the exporter and not of Citibank. Penalties Intentional violations carry a maximum penalty of five times the value of the export, or $1,000,000, whichever is greater, and prison terms of up to ten years. An additional civil penalty includes the cancellation of export privileges which would prevent Citibank from participating directly or indirectly in the export of strategic goods for which approval from the US Department of Commerce or the US Department of State is required. Anti-Money Laundering Transfer from illegal sources to legitimate channels

Money laundering is a term used to describe the process of concealing the existence, illegal source, or illegal application of income. It is the investment or transfer of money flowing from illegal sources into legitimate channels so that the original sources cannot be traced. Banks and other financial institutions unwittingly may be involved in the transfer, deposit, or investment of money that comes from illegal activity. Trade products that unintentionally may facilitate money laundering activities include letters of credit, documentary collections, bankers’ acceptances, and back-to-back reimbursements.

The Money Laundering Process There are three independent activities in the money laundering process.

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n

Placement is the physical action of placing bulk cash proceeds.

n

Layering separates the proceeds of criminal activity from their origins through layers of complex financial transactions.

n

Integration is the act of providing what appears to be a legitimate explanation for the illicit proceeds.

A successful money laundering operation will assure that no “paper trail” connects these three events.

Reporting Requirements The US government has passed two laws that create currency reporting obligations: the Bank Secrecy Act (BSA) and the Money Laundering Control Act (MLCA).

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Bank Secrecy Act

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The Bank Secrecy Act requires banks to file reports and keep records for five years on matters that are useful in investigations of criminal, tax, and regulatory violations. An amendment to this act grants a bank regulator the right to revoke a US bank’s charter, license, and/or deposit insurance if convicted of money laundering crimes. An important BSA report is the Currency Transaction Report (CTR). Citicorp and all of its entities in the United States must file a CTR with the Internal Revenue Service for every cash deposit or withdrawal over $10,000. Citicorp has established a global policy that requires the monitoring of large cash transactions. Outside of the United States, Citicorp recognizes local law requirements for reporting cash transactions to local authorities.

Money Laundering Control Act

The Money Laundering Control Act makes money laundering a federal crime and defines the criminal offenses that are part of the money laundering process. A criminal offense occurs when a person knowingly conducts, or attempts to conduct, transactions using funds derived from illegal activities. The MLCA applies to US citizens and enterprises acting outside US borders, such as Citicorp and Citibank, N.A.

“Know-yourcustomer” policy

The “know-your-customer” policy is an important part of the anti-money laundering program. It requires financial institutions to monitor new and existing accounts to help identify suspicious activities conducted by their customers. Avoiding Problems In order for Citibank to avoid being used to launder money, we should: n

Determine the true identity of all customers that request the Bank’s products and services

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n

Identify customers that seek to conduct significant business transactions as well as those customers using safe-custody facilities

n

Establish transaction profiles for each customer to help predict the types of transactions that are consistent with the customer’s profile

To avoid problems, it is important to be updated continually on US sanctions and US anti-boycott regulations and to know the customer and his/her business plans. The compliance procedures for Latin America, the Middle East, and Africa require a Basic Information Report (BIR) for all new account openings, regardless of whether or not the customer is from a high-risk company.

UNIT SUMMARY At the beginning of Unit 4, we discussed the risks that have the greatest effect on trade transactions. We described the process used by Citibank to assess and manage country (political and crossborder) risk. Based on a risk assessment, the control unit for each country establishes a limit on the amount and type of cross-border business Citibank is able to do with that particular country. To exceed its self-imposed limits, Citibank uses a variety of risk transfer techniques that increase its risk capacity. These include syndication of risk to other banks, insurance policies, guarantees or insurance arranged through export credit agencies, and the sale of risk to thirdparty investors through the forfait market. We identified two agencies that provide insurance for trade transactions: CITI and Lloyds of London. Trade credit insurance and country risk insurance were discussed. Not only do you need to recognize the different types of risk associated with international trade, you also must be aware of the types of insurance that have been developed to reduce those risks.

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We learned about Citibank’s obligation to conform to the laws and regulations of the United States and other countries. It is Citibank’s policy to comply with both US laws and local laws. When conflicts occur, a satisfactory solution should be found that maintains Citibank’s integrity locally and in the United States. In the event that we cannot reach a satisfactory solution, Citibank will always comply with US laws. Supervisors, compliance officers, and legal counsel are available to offer the trade officer any assistance necessary to resolve compliance issues. The trade officer must understand US anti-boycott laws, US sanctions, and US export controls because they affect the flow of goods and services in the global marketplace. If these regulations and their reporting requirements are not properly followed, serious penalties may result. We discussed the money-laundering process and reporting requirements. In order to avoid involving Citibank in money laundering activities, the trade officer must know the customer’s business. You have completed Unit 4, Risk and Compliance. Please complete Progress Check 4.2 to test your understanding of the concepts and check your answers with the Answer Key. If you answer any question incorrectly, please reread the corresponding text to clarify your understanding. Then, continue to the final unit of this workbook, Identifying Customers’Needs and Pricing Solutions.

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PROGRESS CHECK 4.2

Directions: Determine the correct answer(s) to each question. Check your answers with the Answer Key on the next page.

Question 1: Place an X in front of four obligations with which Citibank must comply. _____ a) Boycott requirements that have been imposed by a foreign government _____ b) Trade boycott against Israel by Arab and Islamic countries _____ c) Economic measures against a country that is violating international law _____ d) Rules regarding placement, layering, and integration of cash proceeds _____ e) Guidelines of the Trade Advisory Unit _____ f) US government prohibition of boycott participation _____ g) US Export Controls

Question 2: A boycott is: _____ a) an economic measure adopted by the United States to block the assets of a country’s government. _____ b) an explicit or implied request not to do business with certain persons or companies. _____ c) a specific category of regulations developed to protect the domestic market from foreign competition. _____ d) a quantitative restriction on the import of an article into the United States.

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ANSWER KEY

Question 1: Place an X in front of four obligations with which Citibank must comply. c) Economic measures against a country that is violating international law d) Rules regarding placement, layering, and integration of cash proceeds f) US government prohibition of boycott participation g) US Export Controls

Question 2: A boycott is: b) an explicit or implied request not to do business with certain persons or companies.

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Question 3: When Citibank blocks the account of a specially-designated national, it is complying with: _____ a) US sanctions. _____ b) US anti-boycott laws. _____ c) US export controls. _____ d) the Bank Secrecy Act.

Question 4: The trade officer must know which products are considered “strategic” by the US government in order to comply with: _____ a) US sanctions. _____ b) US anti-boycott laws. _____ c) US export controls. _____ d) the Bank Secrecy Act.

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ANSWER KEY

Question 3: When Citibank blocks the account of a specially-designated national, it is complying with: a) US sanctions.

Question 4: The trade officer must know which products are considered “strategic” by the US government in order to comply with: c) US export controls.

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Question 5: A license to export strategic or high technology must be obtained from the: _____ a) US Department of Transportation. _____ b) Interstate Commerce Commission. _____ c) Securities Exchange Commission. _____ d) US Department of Commerce.

Question 6: The blocking of a government’s assets is an economic measure that is intended to: _____ a) influence the behavior of a government that performs illegal acts according to international law. _____ b) create a balance of trade between two nations. _____ c) correct the illegal behavior of citizens in countries that are official enemies of the US. _____ d) force an alteration of that government’s trade policies.

Question 7: Which two laws create currency reporting obligations? _____ a) International Emergency Economic Powers Act _____ b) Bank Secrecy Act _____ c) Money Laundering Control Act _____ d) US Criminal Code

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ANSWER KEY

Question 5: A license to export strategic or high technology must be obtained from the: d) US Department of Commerce.

Question 6: The blocking of a government’s assets is an economic measure that is intended to: a) influence the behavior of a government that performs illegal acts according to international law.

Question 7: Which two laws create currency reporting obligations? b) Bank Secrecy Act c) Money Laundering Control Act

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Question 8: The “know your customer” policy is a requirement of which compliance issue? _____ a) US export controls _____ b) US anti-boycott _____ c) Anti-money laundering _____ d) US sanctions Question 9: One requirement of the Bank Secrecy Act is: _____ a) a report on all transactions with customers outside the US. _____ b identification of the true identity of all customers that request the Bank’s products and services. _____ c) a CTR filed with the IRS for every cash deposit / withdrawal over $10,000. _____ d) a “paper trail” to connect the three events of the money laundering process. Question 10: An opening bank in Russia issues a letter of credit with 100% cash collateral for confirmation from Citibank, NY. After receipt of the confirmed letter of credit, the beneficiary requests that Citibank, NY cancel the letter of credit. As a result, Citibank, NY must return the cash collateral to the opening bank in Russia. However, the opening bank instructs Citibank, NY to transfer the funds to a third party located in Cuba. What compliance issues may arise from the opening bank’s new instructions? _____ a) Anti-money laundering _____ b) US anti-boycott _____ c) US export control _____ d) US sanction

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RISK AND COMPLIANCE

ANSWER KEY

Question 8: The “know your customer” policy is a requirement of which compliance issue? c) Anti-money laundering

Question 9: One requirement of the Bank Secrecy Act is: c) a CTR filed with the IRS for every cash deposit / withdrawal over $10,000.

Question 10: An opening bank in Russia issues a letter of credit with 100% cash collateral for confirmation from Citibank, NY. After receipt of the confirmed letter of credit, the beneficiary requests that Citibank, NY cancel the letter of credit. As a result, Citibank, NY must return the cash collateral to the opening bank in Russia. However, the opening bank instructs Citibank, NY to transfer the funds to a third party located in Cuba. What compliance issues may arise from the opening bank’s new instructions? a) Anti-money laundering d) US sanction

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Unit 5


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UNIT 5: IDENTIFYING CUSTOMERS’NEEDS AND PRICING SOLUTIONS

INTRODUCTION Your understanding of the trade environment, trade services and finance, and their related risk and compliance issues will enable you to identify and develop new trade-related business for Citibank. In this final unit, we describe the information-gathering process that helps identify a prospective or current customer’s trade-related banking needs. In addition, we explain key pricing benchmarks and provide guidelines for pricing a product. We conclude with a discussion of the procedure for submitting a proposal to a customer. This unit contains a large amount of reference material that will be useful in the future. Keep that in mind as you read through the unit. Feel free to duplicate certain sections for use as quick references.

UNIT OBJECTIVES After completing Unit 5, you will be able to: n

Recognize questions that are used to identify customers’ needs

n

Identify benchmarks that apply to pricing

n

Recognize guidelines used when pricing solutions

n

Recognize the structure of offering letters

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IDENTIFYING CUSTOMERS’NEEDS AND PRICING SOLUTIONS

THE INFORMATION GATHERING PROCESS When a customer approaches Citibank with a business deal or opportunity, we want to obtain sufficient information about the customer’s business to determine his/her needs. This information, combined with knowledge of the trade environment and trade services, enables us to develop a solution that will meet our customer’s needs. In the process, we are able to create new business opportunities for Citibank. Existing Customers Information in customer’s file

If the customer currently does business with Citibank, some information already may be in the customer’s file. For example, if the customer buys raw materials or products on a regular basis from international suppliers and sells to international buyers, the Bank should have a list of these suppliers and buyers. The file also should indicate the total volume of imports and exports as well as the payment options used for settling international trade transactions.

Other internal sources of information

In addition, you may obtain information from the following internal sources: n

n

n

Trade reports, available from the trade product manager Country trade reports on imports and exports, usually kept by product managers Industry analysis and research undertaken by the credit area with the objective of analyzing credit information

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n

n

n

n

n

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Information on the customer’s business revenues (documented in the customer’s Basic Information Report [BIR] which Citibank prepares for each customer) and product / customer revenues (available through various reports, such as the product and account profitability reports, generated by Financial Control – FINCON) Statistics on trade volumes, provided by the customer and kept by the Relationship Manager or the Product Manager Pricing pattern for the customer — examine previous Credit Approvals (CAs) which contain all terms and conditions of credit proposals Balance sheet (e.g. Does the customer have debt? If yes, what is the amount? Is it in US dollars? What is the maturity date?) Previous call plans and call reports

You should talk to the Relationship Manager and Product Specialists who presently work with the account as well as to those who had been previously assigned to the account. They are important sources of information because they can relate past experiences with that customer to reinforce any written information. New Customers When the relationship with the customer is new, the Relationship Manager and the Product Manager’s focus in the first meeting is to assess the customer’s trade business. (Prior to any meeting, you should prepare a detailed call plan based on your informationgathering research so that you can demonstrate your knowledge of the customer’s business.)

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In the first meeting, ask questions to gather current facts and background information. You also should explore any problems, difficulties, and dissatisfactions the customer may have experienced in order to identify areas where Citibank services can help. To understand the customer’s business, you must gather information about his/her product(s), clients and suppliers and their possible financing needs, the customer’s own financing needs, and current trade practices. Try to identify any extraordinary risks as well as customer service issues that may provide opportunities to satisfy his/her needs and build the relationship. The following sets of questions will help facilitate this information-gathering process. Customer’s product mix

The questions below help you obtain information about the customer’s product(s). n

n

n

n

What is the customer’s product offering? Is there a single basic product? Are there other related products? Is all of the customer’s production sold locally? If the answer is “yes,” the customer is not exporting. Otherwise, proceed with the next question. What is the customer’s sales mix between local and international buyers? What is the product mix of the exports? What percentage of sales over the last two years were domestic? What percentage were exports? What will the product mix be for the next year? For the next two years? Will it grow, decline, or remain stable?

The information provided by these questions will help determine if the customer is taking advantage of a temporary market opportunity or is committed to foreign trade. This information is important for pricing our solutions. Customers committed to foreign trade are more price sensitive and efficient since they must compete in the global marketplace.

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Customer’s client (buyer)

The second series of questions concentrates on our customer’s client and its relationship with Citibank. This information is used to identify new business opportunities for Citibank with our customer’s client. n

n

n

Financing needs of the customer’s client

Who are the customer’s principal clients (buyers) abroad? Does the customer know if these buyers are Citibank customers? Would the customer object if Citibank investigated the possibility of meeting the needs of both parties?

The third set of questions focuses on business opportunities relative to the financing needs of the customer’s client. n

n

n

n

n

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Is the customer offering financing terms to his/her buyers? If the answer is “yes,” to what buyers and under which terms? Would it be beneficial to the customer to offer an extension of current financing terms as part of the sales approach to the buyer? Which financing terms would the customer expect to offer (e.g., tenor, price)? Would the customer offer financing terms to all of its buyers or only to some of them? Who are they and in which countries are they located? How would the customer plan to obtain the financing (letter of credit)? If the buyer’s risk is unacceptable to Citibank, is the customer prepared to accept the discount with recourse? This means that if the buyer does not pay, Citibank’s customer will be liable for payment at maturity.

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Customer’s suppliers


The next set of questions focuses on the customer’s suppliers. n

Does the customer purchase all supplies in the country? If the answer is “yes,” proceed to the question below. Otherwise, move to the next bulleted question. When the customer purchases supplies locally, are the supplies manufactured locally, or are they imported and then purchased from local representatives?

n

n

n

n

Other financial needs

•

If the answer to either of these questions is “yes,” has the customer considered importing supplies directly?

•

If the customer does not import directly because of policy decisions or other technicalities, are there plans to make changes? If there are, record this information for follow-up during the next visit.

•

If the customer does not import directly because of purchasing terms, what payment terms will encourage him or her to consider direct imports?

Who are the customer’s largest suppliers? Be sure to get this information for each product. In what countries are the suppliers located? Do the suppliers provide financing terms? Do the terms meet this customer’s needs? Are the offshore suppliers also Citibank’s customers? If the answer is “no,” ask if the customer objects to the bank’s investigating the possibility of serving the needs of both parties.

So far, we have questions for collecting information on our customer’s products, the customer’s client and possible financing opportunities, and the customer’s suppliers and possible financing opportunities. The purpose of the next two questions is to identify any other financial needs of the customer.

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n

n

Customer’s current trade practices

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Does the customer need additional financing? If the answer is “no,” investigate the supplier’s financing costs. Citibank may be able to offer better financing. Which tenor is the customer seeking? If the tenor is acceptable to the customer, investigate the amount needed, payment schedule, etc.

At this point, the Relationship Manager and/or Product Manager should know about the customer’s buying and selling processes, any offshore suppliers, and its financing terms. The next series of questions focuses on the customer’s current trade practices. n

Extraordinary risks

5-7

How many banks are involved in processing the customer’s trade transactions and trade financings? How does the customer pay for imports? Are there any offshore Demand Deposit Accounts (DDAs)? Does the customer collect the payments for the exports locally and/or through an offshore DDA (e.g., NY, London)? Does the customer operate on open account, documentary collections, or letters of credit basis? In terms of documentary collections and letters of credit, do we have information on: •

Total annual volume?

•

Number of trade transactions?

•

Local banks used?

•

Export credits the customer may be receiving (find out from where, which banks are involved, and the payment terms)?

•

Pricing (including fees and minimum commission)?

The purpose of the next question is to identify any extraordinary risks that might affect the Bank.

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n

Customer service

Does the customer plan any business expansion or new investments that may raise medium-term financing for capital goods?

The final questions focus on customer service, which is always part of our ongoing efforts in assessing our customer’s needs. n

n

n

What are some of the trade-related needs that the customer feels are not being properly serviced or that could be improved? Is the customer satisfied with the way we provide services? Are we fulfilling our customer’s expectations in terms of timely and accurate services? Is there any other information the customer could provide that would enable us to improve our services and add value to our customer relationship?

Once the information-gathering process is completed, the next step is to structure a solution that meets the customer’s needs and also is profitable for the Bank. The structure of the solution is based on Citibank’s product offerings.

KEY PRICING BENCHMARKS Basic benchmarks that the Bank defines for a country and/or a region, plus data from the market, must be considered in pricing the solution that has been structured for the customer. These benchmarks include: n

Minimum return on cross-border risk

n

Expected return on assets

n

Revenue to expense ratio

n

Market quotations for similar risks

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5-9

Minimum Return on Cross-Border Risk The movement of funds across borders introduces potential difficulties in terms of currency management, exchange regulations, taxation, and timing. Restrictions on moving funds out of a country may occur as the result of economic problems, political instability, or sovereign actions within the country. Citibank must assess the size of cross-border risk (transfer and convertibility risks) associated with each transaction and the amount the Bank needs to make on a transaction in order to obtain a return on the risk. Example: Size of crossborder risk

For example, in a pre-export financing, the seller (exporter) has a firm contract of sale and needs financing to acquire and prepare goods for shipment. The seller obtains a loan from the bank in the importer’s country to prepare and ship the goods to the importer. The importer will now have to repay the loan directly to the lending bank in its country. This financing has a lower cross-border risk because the proceeds from the importer are applied locally for the repayment of the loan. Consider now an import financing, where the buyer (importer) is purchasing goods under a sight letter of credit and needs financing to meet the required payment under the credit. There is a higher cross-border risk because local funds must be converted into hard currency and transferred offshore in repayment. These differences are reflected in the size of the margin and the sublimits for the different types of transactions. Remember, Citibank in each country / region is assigned a crossborder limit on the amount of funds that may carry cross-border risk. Within each overall limit are sublimits for each type of product and tenor. For instance, the cross-border trade limit for Brazil may be $200MM, with $150MM designated for short-term trade (e.g. $100MM for pre-export financing and $50MM for import financing) and $50MM allocated to medium-term trade (e.g. $40MM for preexport financing for up to two years and $10MM for import financing between 2 and 3 years).

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Expected Return on Assets Measure use of assets to generate earnings

The second factor to consider in pricing is the expected return on assets. This is the total shareholder equity calculated as a percentage of total assets. The return on assets ratio measures the Bank’s performance in using assets to generate earnings. Banking laws in all countries require a minimum assets-to-capital ratio. The ratio is affected when assets are booked at a very low margin. Citibank may be required to increase capital before it can book additional assets when revenues do not increase the net worth in proportion with the growing assets. At the corporate level, the expected return on assets is implied in the budget through the expected level of assets. At the country level, the expected return on assets is implied through a minimum return. Balance sheet ratios indicate the wealth of a company. It is important for Citibank to keep a healthy return on assets ratio to remain attractive to shareholders and investors. Revenue-to-Expense Ratio

Expenses incurred to produce revenues

The revenue-to-expense ratio is another factor in pricing a product. Externally, the Bank’s efficiency is measured by rapid and low-cost satisfaction of customer needs. Internally, efficiency is measured by the amount of expenses incurred to produce a predefined level of revenues.

Example

For example, Citibank is trying to achieve a net revenue-to-expense ratio of 4:1 (four dollars in revenues for each dollar spent). This net figure represents a complex mix of products which includes laborintensive products such as trade transactions. The ratio for trade products usually does not exceed 1.5:1 (one and a half dollars in fees for each dollar in expenses). The less labor intensive products, such as capital markets, can achieve a 10:1 ratio. When determining price, it is important to consider all the processing that is required to support a product.

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Market Quotations for Similar Risks Monitor current market conditions

Citibank’s involvement in local markets requires constant monitoring of current market conditions, which are used as a benchmark to review, update, and optimize the Bank’s pricing.

Example

For example, Citibank may decide that the minimum return on crossborder risk is 4% per annum and that the Bank must charge a fee of at least $2,000 for an import letter of credit to maintain an acceptable revenue-to-expense ratio. If the market moves to a 3% per annum spread and a $500 fee, the Bank can either lower its prices or risk losing the business. An alternative may be to improve the pricing by reducing the costs associated with fees. This alternative involves a higher level policy decision, possibly requiring a change in market strategy followed by a strong, clear, accurate action plan. At this stage, the product is defined and key benchmarks of pricing are analyzed. Now, you must determine the right price to quote to the customer.

PRICING GUIDELINES

Risk Identification In simple terms, pricing is the placement of a dollar value on the risks involved in a transaction. It is necessary to identify and quantify the different risks associated with a transaction in order to determine the price. Questions that identify risk

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The following questions will help to identify the risks: n

Is country risk involved?

n

Is credit (commercial) risk involved?

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n

n

n

Is a third-party risk involved? (e.g., the confirmation of an export letter of credit) Is this a one-time quotation? (e.g., a pre-export financing to be disbursed the following week) Is the risk extended over a period of time? (e.g., a quotation of $40MM of pre-export financing to be disbursed within the next seven months)

The time element is particularly important in emerging economies due to the high volatility of market prices. If the Bank sets the price too low and market prices increase, the Bank may lose money. If the price is too high, the customer may take his/her business elsewhere. If volatility is high or the spread (interest increment charged over LIBOR) is expected to increase, the quotation may be given with the condition that the rate may be adjusted if market rates go over “X”% of the quotation. Both parties would have to negotiate the rate adjustment. General Guidelines Key points to consider

Use the following guidelines as a reference for pricing. They include the key points to be considered for the most commonly used transactions. Documentary Collections, Transfers, and Payment Orders For documentary collections, funds transfers, and payment orders: n

Quote a flat fee (e.g., $15 or $20 for a funds transfer) for multiple, low-value operations. The fee works as a minimum commission but, from a sales point of view, it is easier to explain to the customer.

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n

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Quote a commission (e.g., 0.1%) with a minimum (e.g., $80 per item) when the value per transaction and number of transactions is unknown, or very large, or when the customer has a large volume of transactions with a wide range of values. When pricing the minimum commission, consider internal costs (e.g., cost of handling the documentary collections, cost of funds transfer, cost of payment order) which vary and fluctuate from country to country. The Product Manager in each country has this information.

n

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Use innovative pricing models, such as the global commission, when the Bank knows the customer’s business very well. Consider how much the customer currently is paying for this product.

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Import Letters of Credit For import letters of credit, the following considerations should be addressed: n

n

n

ALADI — Does the letter of credit involve sovereign exposure or is it an ALADI letter of credit? For ALADI there is no cross-border risk since it is equivalent to a letter of credit with local currency. The seller is paid in its country’s local currency and the buyer pays in its country’s local currency. “All-in” Quote — The “all-in” quote includes correspondent bank charges. It is important to know the fees charged by the correspondent banks since more customers are requesting this type of quote. Global Finance MIS — This reporting allows the capture of all customer-related revenues at a local level, irrespective of the country from which it is collected, as well as the corporation as a whole. For an import letter of credit, the local branch, as the issuing bank, charges for the commercial and country risks which are implicit in the transaction. Additionally, Citibank abroad receives advising, confirmation, and export credit negotiation fees. As a result, the country’s local branch trade business unit will be looking at the offshore revenue as “customer revenue” not collected locally. This revenue assignment should not be used to reduce the fees collected from the importer for the risks Citibank is assuming locally.

n

Out-of-pocket expenses — Who is going to pay the out-ofpocket expenses (e.g., telexes, faxes, couriers, postage)? Are they included in the pricing? If these expenses are included, the customer should be notified that the quotation is free and clear of any further charges. If these expenses are not included in the quotation, the customer should be informed that s/he will be charged for them.

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“Flat fee” or per annum (p.a.) — The price for opening an import letter of credit can be quoted either as a flat fee or on a per annum basis. In the case of a flat fee, the customer will pay a fixed percentage, e.g. 3%, of the total amount of the letter of credit independent of its tenor. The correspondent bank’s expenses may, or may not, be quoted as part of this fixed fee structure. For instance, a bank that opens an import letter of credit in the amount of $100M may charge a flat fee of 3%, but does not include the correspondent bank’s expenses. The issuing bank’s charge to the applicant would be $100M 5 0.03 = $3M. If we quote on a per annum basis, the calculation of the charge will be based on the amount, spread, and tenor of the transaction. For instance, if a bank charges 3% per annum for a letter of credit for $100,000, and the validity period is 90 days plus 180 days of deferred payment, the total tenor for this transaction will be 270 days. The calculation of the charge for this transaction will be (100,000 5 0.03 5 270) / 360 = 2,250. The correspondent bank’s charges may be treated independently unless we have some kind of agreement on the cost to be charged by them.

Export Letters of Credit When pricing export letters of credit, use the following guidelines: n

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Advise and negotiation — If the credit is a large one with multiple shipments and/or negotiations, the bank should clearly state the number of negotiations included in the quotation and the pricing for each additional negotiation.

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n

n

n

Confirmation fees — It is important to know the bank and the location of the confirming bank. There could be a different quotation when a letter of credit is issued by a different branch. The product managers can provide assistance with this type of situation. Transferable L/C — The fee for a transferable letter of credit should be indicated, even if it is a nominal fee. “All in” for the importer — When the opening branch requests a quotation, items included in the quotation should be stated. Charges, if any, that are to be collected separately or based on volume (such as the negotiations) should also be priced.

Trade Finance In the trade finance area, the following information will help to determine pricing. n

When LIBOR? — LIBOR is quoted when the tenor is fixed (e.g. import financing). Prepayment of transactions priced on LIBOR incurs a penalty fee plus the LIBOR differential for the remaining period (charged by the treasury). We further explain this in the example that follows.

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Example

For instance, suppose a customer obtains $100M of import financing for 180 days at 7.75% p.a. (LIBOR 5.75% p.a. plus a spread of 2.0% p.a.). As a result, the bank’s treasury borrows funds from the money market at 5.75% p.a. interest rate for 180 days. However, if the customer decides to prepay the loan in 90 days, s/he may face two opposing scenarios. If LIBOR for the remaining 90 days of the loan is lower, i.e. 5.25% p.a., the treasury stands to lose 0.5% p.a. (5.75% p.a. – 5.25% p.a.) since it borrowed at a higher rate from the local money market and now the market is offering a lower rate. The LIBOR differential of 0.5% p.a. will have to be charged back to the customer: (100M 5 90 5 0.005) / 360 = $1.25M. On the other hand, if LIBOR for the remaining 90 days is the same (e.g. 5.75% p.a.) or higher, the treasury gains from the transaction and will not charge any LIBOR differential to the customer. n

n

n

n

n

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When Prime? — The prime rate is quoted when the repayment is tied to an event where the date cannot be specifically determined — for example, a pre-export financing. Revenue comes from the difference between the pool rate (equivalent to LIBOR) and the prime plus spread. The prime rate changes on a daily basis and may be lower or higher than LIBOR. Guarantees and collateral — The risk of guarantees and the value of collateral must be considered in the pricing. Market rates — How do Citibank’s rates compare to current market rates? Innovation — The customer’s business should be reviewed with the Product Manager to uncover tax advantages. Tax savings to the customer may improve the bank’s price. Be innovative! Floating and fixed rates — Part of the period may be quoted based on a fixed rate (e.g. LIBOR) and the remainder of the period based on the equivalent prime rate (floating rate).

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Example

*

Suppose a customer requests a 180-day pre-export financing in which the total rate for 150 days is 7% p.a. (LIBOR 4% p.a. plus 3% spread) and the remaining 30 days at prime* (6.5% p.a.) plus 1% spread. During the first 150 days, the customer pays a fixed rate of 7% p.a. of the amount of the loan. For the remaining 30 days, the customer pays a floating rate since the prime varies on a day-today basis. On Day 1 of the 30 days, the prime rate is 6.5% p.a., but on Day 2 it could be 7% p.a., Day 3 7.15% p.a., and so on. If the prime rate ends higher at the end of the 30 days, the customer pays more for the loan than the initial rate quoted for the first 150 days.

In this case, the prime is 6.0% p.a., not 6.5% p.a. — or the spread is 0.5% p.a. You must have the same total rate of 7.00% p.a. The idea is that when you price to the customer, you prepare the quotation based on current rates and the differential; i.e.: Day 1: LIBOR = 4.00% p.a., Prime = 6.50% p.a., and Spread = 3.00% p.a. You will quote LIBOR plus spread: 4 + 3 = 7.00% p.a. for the first 150 days For prime, we also have to achieve the 7.00% p.a.; so, the loan will be booked at prime plus spread: 6.5% p.a. + 0.50% p.a. = 7.00% p.a. Both the customer and the bank run the risk of prime’s variation. If the prime goes up, the customer pays more than expected for the loan; if the prime goes down, the bank gets less than expected.

n

Bundled with transactions — For example, an attractive L/C fee may be quoted if subsequent financing is to be provided by the Bank. Take into account the aggregate when more than one product is involved.

Selling Trade Paper When selling trade papers (e.g. drafts, banker’s acceptance), it is important to consider the following: n

n

Participations — The percentage of the Bank’s participation, as well as the risks involved (country and/or commercial), should be stated. Forfaiting — The quotation for selling the paper is what the Bank will receive for the period accrued as of the date of sale.

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n

5-19

Selling Export Credit Agencies (ECAs) — The market price varies if a full comprehensive guarantee has been obtained. The structured trade finance coordinator can guide the trade officer through the process. Usually the paper is sold by the United States or European distribution teams at Citibank who are more acquainted with the market.

PRESENTING THE OFFER TO THE CUSTOMER Once you have structured and priced the solution, you are ready to present the proposal to the customer. In this section, we examine the format and content of the initial letter sent to the customer — called an “indicative offer.” It is an explanation of the Bank’s proposal and not a commitment to provide financing. The indicative offer is sometimes confirmed by a second letter, the “firm offer.” Format of the initial letter

To begin, it is important to use the correct stationery with the most recent letterhead. The language should be direct and concise. Every number must be checked to ensure that it is correct. All of the conditions must be stated in the letter. Copies should be made and distributed to all persons involved in the implementation and delivery of the proposal. Here is an explanation of the contents of the indicative offer letter that can be found in the sample in Figure 5.1. A sample of a firm offer may be seen in Figure 5.3.

Format of the indicative letter

Heading — The heading of the offering letter should include the date and the department from which the offer originates. If the letterhead is printed, only the date is required. Addressee — The offering letter must be addressed to the correct person and department in the company to which the offer is being made. If necessary, copies may be made for other departments or persons involved in the transaction.

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Situation — A brief description of the situation should be in the letter. For example, “During our meeting last Monday, we discussed your need to export a certain amount of . . .” Proposal statement — It is important to state that the letter is a proposal. It will be effective and binding whenever signed and agreed to by the customer or an authorized person from the Bank. Terms and conditions — The letter must state precise details on the terms and conditions of the offer, such as tenor, pricing, and legal vehicles involved. The price must include the costs, the base rate for computing the interest, whether or not an advance payment is required, and any other issues that relate to the price and cost of the offering. This information may be included in the body of the letter or in the Annex to the letter (see Figures 5.2 and 5.4). Acceptance procedure — The letter must explain the procedure for accepting the offer, important deadlines or milestones, documents required, etc. Signature — The offering letter must be signed by the Relationship Manager or Product Manager. (Send a copy to the Manager that did not sign the letter.)

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January 20, 1999 (Name and Title) Tractores Butterfly Address City, State ZIP Dear Mr. or Ms.: At our last meeting, January 15, 1999, you stated that you were looking for an adequate alternative of funding for your production of farm tractors for export. Your monthly production is 30 farm tractors for the local market and 40 for export. We discussed alternatives to the financing of raw materials for the production of 40 farm tractors. At this time, we would like to present a feasible option. Considering your requirements, we think the most suitable product for your company is pre-export financing. The enclosed terms and conditions are presented on an indicative basis only and are subject to our own internal credit approvals and the current market situation at the time of the contemplated financing. This proposal is not a commitment to provide financing. It is an indication of the terms and conditions which we believe might be attractive based on the current market situation. The availability of these terms and conditions depends on the financial condition of Tractores Butterfly, the market, and political and regulatory conditions at the time of any potential commitment. If you agree with the attached terms and conditions, please sign and return a copy of this letter of acknowledgment. This proposal expires on January 30, 1999, unless renewed in writing. We would appreciate the opportunity to work closely with you on this transaction and look forward to hearing from you. Yours sincerely, Product Manager cc: Relationship Manager

Figure 5.1: Indicative offer letter

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ANNEX Summary of Indicative Terms and Conditions Borrower / Exporter:

Tractores Butterfly

Lender:

Citibank N.A. or any of its subsidiaries or affiliates

Purpose:

Financing for the production of 40 farm tractors for export

Type of Facility:

Pre-export finance Short-term facility

Principal Amount:

Up to USD 1,200,000

Tenor:

Up to 180 days

Interest Rate:

6 months LIBOR plus a margin of 2.25% per annum, payable at maturity

Documentation:

Promissory Note subscribed to by the borrower corresponding to the repayment of principal and interest

Taxation:

All amounts payable under the Facility will be paid free and clear of all present and future taxes, withholding, duties, or other deductions whatsoever.

Governing Law:

New York

Figure 5.2: Annex to the indicative offer

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January 20, 1999 Name and Title Tractores Butterfly Address City, State ZIP Dear Mr. or Ms.: You have requested Citibank to explore the possibility of arranging financing for the production of 40 farm tractors for export. In response to your request, we are pleased to confirm our offer, subject to your acceptance of the enclosed summary of indicative terms and conditions, on the basis of which Citibank N.A., or any of its affiliates and subsidiaries (“Citibank”), might be in the position to arrange financing for the above project. Please confirm your acceptance of the present offer by returning to us a copy of this letter by close of the business day January 30th, 1999, at which time this offer shall otherwise expire. We look forward to hearing from you. Yours sincerely,

Figure 5.3: Firm offer letter

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ANNEX Summary of Indicative Terms and Conditions Borrower / Exporter:

Tractores Butterfly

Lender:

Citibank N.A. or any of its subsidiaries or affiliates

Purpose:

Financing for the production of 40 farm tractors for export

Type of Facility:

Pre-export finance Short-term facility

Principal Amount:

Up to USD 1,200,000

Tenor:

Up to 180 days

Interest Rate:

6 months LIBOR plus a margin of 2.25% per annum, payable at maturity

Documentation:

Promissory Note subscribed to by the borrower corresponding to the repayment of principal and interest

Taxation:

All amounts payable under the Facility will be paid free and clear of all present and future taxes, withholding, duties, or other deductions whatsoever.

Governing Law:

New York

Figure 5.4: Annex to firm offer

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UNIT SUMMARY An important factor in developing trade-related business is to recognize the needs of our existing customers and potential customers. We began this unit by describing the internal sources for information regarding existing customers. We also recommended a series of questions for interviewing new customers. The questions focused first on the customer’s business and then on the customer’s clients and suppliers. The objective is to identify the customer’s needs in order to structure the best solution to meet those needs. We considered the factors that affect pricing: minimum return on cross-border risk, expected return on assets, revenue to expense ratio, and market quotations for similar risks. We discussed risks that affect product pricing and presented guidelines for pricing the different products. Finally, samples of letters for submitting and confirming a proposal to the customer were explained and presented.

You have completed Unit 5, Identifying Customers’Needs and Pricing Solutions. Please complete the Progress Check to test your understanding of the concepts and check your answers with the Answer Key. If you answer any question incorrectly, please reread the corresponding text to clarify your understanding. After finishing the Progress Check, you will have completed this course on Basics of Trade Services and Trade Finance. Congratulations! You may wish to duplicate several sections of this unit to serve as quick references or reminders when you prepare to interview new customers, work through the pricing process, and prepare the offer to the customer. Good luck!

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PROGRESS CHECK 5

Directions: Determine the correct answer(s) to each question. Check your answers with the Answer Key on the next page. Question 1: Match each type of information about a potential customer with its internal Citibank source. Write the number of the source on the line next to the type of information. _____ a) _____ b) _____ c) _____ d)

Industry analysis and research Statistics on trade volumes Country trade reports Product / customer revenues

1) 2) 3) 4)

Credit area Trade product management unit FINCON

Relationship or product manager

Question 2: An interview with a prospective customer occurs and questions are asked to identify the prospect’s needs. Match the type of information the banker is trying to uncover with the following questions. Write the number of the type of information on the line next to the questions. You may use a number more than once. _____ a) What does the customer sell? How much is sold locally? How much is exported? _____ b) Does the customer purchase all supplies within the country? _____ c) Does the customer offer financing terms to his/her buyers? _____ d) Who are the customer’s offshore buyers? _____ e) How does the customer pay for imports? _____ f) How many banks does the customer use to process trade transactions? _____ g) Does the customer feel that there are any trade-related needs that are not being properly addressed? 1) 2) 3) 4) 5) 6)

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Customer’s current trade practices Product mix Suppliers Customer’s client Financing to the customer’s client Customer service

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ANSWER KEY

Question 1: Match each type of information about a potential customer with its internal Citibank source. 1

a) Industry analysis and research

1) Credit area

4

b) Statistics on trade volumes

2) Trade product management unit

2

c) Country trade reports

3) FINCON

3

d) Product / customer revenues

4) Relationship or product manager

Question 2: An interview with a prospective customer occurs and questions are asked to identify the prospect’s needs. Match the type of information the banker is trying to uncover with the following questions. Write the number of the type of information on the line next to the questions. You may use a number more than once. 2

a) What does the customer sell? How much is sold locally? How much is exported?

3

b) Does the customer purchase all supplies within the country?

5

c) Does the customer offer financing terms to his/her buyers?

4

d) Who are the customer’s offshore buyers?

1

e) How does the customer pay for imports?

1

f) How many banks does the customer use to process trade transactions?

6

g) Does the customer feel that there are any trade-related needs that are not being properly addressed? 1) 2) 3) 4) 5) 6)

Customer’s current trade practices Product mix Suppliers Customer’s client Financing to the customer’s client Customer service

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Question 3: Identify the key benchmark associated with each of the following situations. Write the number of the benchmark next to the situation. _____ a) The banker evaluates current market conditions before pricing an import letter of credit. _____ b) The product most suitable for the customer is labor intensive for the Bank. _____ c) In a foreign exchange transaction, regulations may prohibit the conversion of local funds to hard currency. _____ d) If Citibank wants to book more assets, it may have to put up additional capital. 1) 2) 3) 4)

Minimum return on cross-border risk Expected rate of return on assets Market quotations for similar risks Revenue-to-expense ratio

Question 4: Place a T in front of the true statements and an F in front of the false statements. _____ a) When pricing collections, transfers, or payment orders, quote a flat fee for a large number of transactions. _____ b) It is necessary to know if an import letter of credit involves sovereign exposure. _____ c) A local bank should reduce pricing for customers when it receives offshore fees as “customer revenue” not collected locally. _____ d) When the export credit is a large one with multiple negotiations, roll the costs for each negotiation into one quoted figure. _____ e) Use LIBOR when the tenor is fixed. _____ f) When selling trade paper, the quotation for a forfait is what the bank will receive for the period accrued as of the date of the sale of the paper.

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ANSWER KEY

Question 3: Identify the key benchmark associated with each of the following situations. Write the number of the benchmark next to the situation. 3

a) The banker evaluates current market conditions before pricing an import letter of credit.

4

b) The product most suitable for the customer is labor intensive for the Bank.

1

c) In a foreign exchange transaction, regulations may prohibit the conversion of local funds to hard currency.

2

d) If Citibank wants to book more assets, it must put up additional capital. 1) 2) 3) 4)

Minimum return on cross-border risk Expected rate of return on assets Market quotations for similar risks Revenue-to-expense ratio

Question 4: Place a T in front of the true statements and an F in front of the false statements. F

a) When pricing collections, transfers, or payment orders, quote a flat fee for a large number of transactions.

T

b) It is necessary to know if the import letter of credit involves sovereign exposure.

F

c) A local bank should reduce pricing for customers when it receives offshore fees as “customer revenue” not collected locally.

F

d) When the export credit is a large one with multiple negotiations, roll the costs for each negotiation into one quoted figure.

T

e) Use LIBOR when the tenor is fixed.

T

f) When selling trade paper, the quotation for a forfait is what the bank will receive for the period accrued as of the date of the sale of the paper.

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Question 5: The proposal is submitted to the customer via the offering letter. Which of the following are included in the letter? _____ a) Date and address of the department that is making the offer _____ b) Letter should be addressed to the president of the company _____ c) Explanation of the correct procedure for accepting the offer _____ d) Base interest rate _____ e) Letter must be printed on letterhead from the legal department

Question 6: A Peruvian exporter is selling textiles to Germany in the amount of USD 50 MM per annum. The export sales are cyclical and occur from May to September. The exporter needs funds to produce the goods to be exported, for an amount of USD 15 MM for 270 days. The Citibank branch in Peru approved the credit, and the Relationship Manager (RM) confirmed the line of credit with funds to be disbursed at LIBOR (6.0% p.a.) plus 2.0% p.a. spread. The exporter may be able to repay part or all of the loan after the first 180 days by using the proceeds from the shipments made during the export cycle. What pre-export financing arrangement will best meet the exporter’s needs? Assume that PRIME is 6.5% p.a. _____ a) 180 days at LIBOR plus 2.00% p.a., 90 days at Prime plus 1.5% p.a. _____ b) 270 days at LIBOR plus 2.00% p.a. _____ c) 270 days at Prime plus 2.00% p.a. _____ d) 270 days at Prime plus 1.50% p.a. _____ e) 180 days at LIBOR plus 2.00% p.a.; 90 days with LIBOR differential charged back to the customer if LIBOR rates go up.

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ANSWER KEY Question 5: The proposal is submitted to the customer via the offering letter. Which of the following are included in the letter? a) Date and address of the department that is making the offer c) Explanation of the correct procedure for accepting the offer d) Base interest rate Question 6: A Peruvian exporter is selling textiles to Germany in the amount of USD 50 MM per annum. The export sales are cyclical and occur from May to September. The exporter needs funds to produce the goods to be exported, for an amount of USD 15 MM for 270 days. The Citibank branch in Peru approved the credit, and the Relationship Manager (RM) confirmed the line of credit with funds to be disbursed at LIBOR (6.0% p.a.) plus 2.0% p.a. spread. The exporter may be able to repay part or all of the loan after the first 180 days by using the proceeds from the shipments made during the export cycle. What pre-export financing arrangement will best meet the exporter’s needs? Assume that PRIME is 6.5% p.a. a) 180 days at LIBOR plus 2.00% p.a., 90 days at Prime plus 1.5% p.a. This is the best alternative considering that the customer will be able to repay after the first 180 days, because he has a fixed rate for the first 180 days, and has the volatility of the Prime rate only from day 181 to the actual repayment date. Also, he does not have a prepayment fee, since he is financing the second part at prime. The problem with answer (b) is the prepayment penalties for the last 180 days, when the customer will be applying the funds received for his exports. Answer (c) is not the solution because of the spread. When we quote the relation between Prime and LIBOR to customers, it must result in the same total rate for the financing — in this case, 8.00% p.a. Unless specifically stated in the documentation, the rate is agreed for both periods beginning on Day One. You may have considered answer (d), but it is only partially correct in best meeting the exporter’s needs because the exporter (in fact, both the bank and the customer) is running the prime volatility for the whole period, instead of only for those days from Day 181 to the actual repayment date.

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Question 7: Which one of the following statements is true? _____ a) For ALADI letters of credit, pricing must take into account the added cross-border risk. _____ b) For import letters of credit, an “all-in” quote includes correspondent bank charges. _____ c) For low-value, multiple funds transfers, a commission rate with a minimum price should be quoted. _____ d) Prime rate should be quoted when the tenor is fixed.

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ANSWER KEY

Question 7: Which one of the following statements is true? b) For import letters of credit, an “all-in” quote includes correspondent bank charges.

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Appendices


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APPENDIX A GLOSSARY Acceptance

Time draft or bill of exchange that represents a promise made by the buyer to honor the instrument at maturity. An acceptance is created when the drawee places the word “accepted” across the face of a draft, followed by the date and signature of the acceptor.

Acceptance Commission Rate

Component of acceptance financing cost which compensates the bank for its assumption of credit risk and covers the administrative costs of the transaction

Acceptance Discount Rate

Discount to the face value of a draft in a banker’s acceptance financing. This component of acceptance financing represents the bank's charge for the use of funds as well as the rate earned by the bank or an investor.

Acceptor

Party that agrees unconditionally to pay the draft at maturity

Advising Bank

A bank in the beneficiary’s country — usually a correspondent of the issuing bank — through which the issuing bank communicates the credit to the beneficiary

All-In Quote

A quotation to a customer that includes all fees charged by the banks involved in a trade transaction, both local and correspondent banks.

All-In Rate

An interest rate quoted to a customer that contains all the elements of the bank’s costs and profit built into that rate. It is the total return the bank earns, and effectively measures the customer’s true cost.

Allocating Cross Border

Citibank approval process for amount and type of business that can be done “cross border” with any particular country

Analysis Certificate

Document used for mineral or chemical purchases to verify the percentage of each component

Applicant

Party (importer) that arranges for a Letter of Credit to be issued

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GLOSSARY

Asociación LatinoAmericana de Integración (ALADI)

Organization of Latin American countries that provides members with a source of financing for Latin American intraregional trade


Instructions of the beneficiary to the paying bank to pay all, or a portion of, the proceeds of a Letter of Credit to a third party (assignee)

Aval

Unconditional and irrevocable guarantee established by signing a promissory note or bill of exchange. By signing the note, the bank or other party commits itself to pay should the drawee default.

Bank Secrecy Act (BSA)

US law that requires banks to file reports and keep records

Banker’s Acceptance

Time draft drawn by the buyer on a bank and accepted by the bank which will pay another party a stated amount on a predetermined future date. In a banker’s acceptance, payment at maturity is assured by a bank.

Bank-to-Bank Reimbursement

A trade product that is used when the letter of credit transaction between the applicant and beneficiary from different countries is denominated in a third-country currency, usually US dollars

Basic Information Report (BIR)

Document used for all new account openings in Latin America to indicate that the bank has followed the knowyour-customer policy, and that dealing with the customer constitutes an acceptable, minimal risk

Beneficiary

Party in whose favor the credit is issued (e.g. exporter or seller). The beneficiary can draw funds from the paying bank.

Bid Bond

Instrument designed to ensure that the tenderer (e.g., supplier) will honor its commitment to a buyer when bidding for a construction or supply contract

Bill of Exchange

Unconditional order written from one person (the drawer) to another person (the drawee), directing the drawee to pay a certain sum at “sight,” or at a fixed or future date to be determined, to the payee.

for five years on matters that are useful in investigations of criminal, tax, and regulatory violations

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GLOSSARY

A-3

Bill of Lading

Transportation or shipping document, issued by the transportation company when moving goods, that provides evidence of receipt of goods for shipment, a contract for transportation, and documentary evidence of title on goods

Bond

Instrument designed to ensure commitment made by one party (the bank) to another party (the obligee) pledging to cover for financial loss caused by the act of default of a third party (the obligor – the bank’s customer)

Boycott

Explicit or implied request by a company or individual not to do business with certain persons or companies

Bundled with Transactions

Pricing which takes into account the aggregate of products sold to the customer

Buyer’s Credit Financing

A financing arrangement under which a lending bank in the supplier’s country lends directly to the buyer, or to a bank in the buyer’s country, to enable the buyer to make payments due to the supplier under the contract. The loan is insured by an export credit agency, and the lending bank usually receives a subsidy from its ECA.

Cash in Advance

Payment method in which the seller receives cash from the buyer before goods are shipped or services are rendered


Document that states where goods were manufactured or grown

Channels of Trade

The time required for preparation for shipment, transport, receipt, and resale of goods

Citicorp International Trade Indemnity, Inc. (CITI)

A Citicorp subsidiary that underwrites trade-related insurance (political risk, trade credit risk, and marine cargo) for Citicorp entities, corporate and bank customers, and other entities who participate in the flow of capital and commerce across borders

Clean Risk

One hundred percent risk that one party has honored its part of the deal and cannot withdraw payment before the counterparty goes bankrupt and defaults

Commercial

A fixed rate; typically the rate in effect at the time the ECA

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GLOSSARY

Interest Reference Rate (CIRR)

approves the export transaction as eligible for its support

Commercial Invoice

Billing document issued by the seller and addressed to the buyer that gives a description of the goods or services, price, charges, etc.

Commercial Risk

Possibility that the borrower is unable to generate sufficient local currency to purchase the necessary amounts of foreign currency to repay the financing (see Credit Risk)

Compliance

Compliance is the act of conforming to a rule or demand. In banking, the term refers to conformance with legal and regulatory obligations in the countries of business.

Confirming Bank

The bank which, under instruction in a Letter of Credit, adds its own irrevocable undertaking to that of the issuing bank and assumes the ultimate obligation to pay on the Letter of Credit

Consignee

Importer or agent responsible for paying for goods if and when they are sold

Consignment

A method of payment for goods where the title of the goods remains with the supplier / manufacturer until they are sold by an agent or third party

Contingent Lending Risk

Possibility that potential customer obligations will become actual obligations and will not be settled on time

Contract Frustration

Primary type of private insurance coverage for the commercial and country risks of international trade; covers non-payment resulting from specific country risks

Convertibility Risk

Risk which exists in any transaction in which legal or regulatory barriers prevent the borrower from converting its local currency into the foreign currency required for payment when the obligation in that currency matures. Possibility that a local currency will not be convertible to the currency needed to make payment to an exporter.

Correspondent

A bank that provides services to another bank, including funds transfers, trade transactions, and financings. In order v-2.1

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GLOSSARY

A-5

Bank

to operate appropriately, at least one of them should hold an account in the other one.

Counterparty

Customer with whom the bank has a contract to simultaneously pay agreed values at a stated future date

Counterparty Risk

Possibility that a counterparty may default on a contract

Country Risk

Possibility that the counterparty’s country may experience political or economic instability that makes it impossible to get money or physical assets out of that country (See also Cross-Border Risk)

Country Risk Insurance

Insurance issued to protect against losses resulting from actions or inaction of a sovereign government

Credit Line

Maximum amount that a bank’s customer is entitled to borrow during any period of time. This amount enables that customer to initiate various loan transactions as long as their total amount does not go over, at any time, the limit amount under the customer’s credit line.

Credit Risk

Possibility that a borrower will be unable to repay a loan on time or repay it in full (also known as Commercial Risk)

Cross-Border Risk

A form of Country Risk (also includes Political [Sovereign], Transfer, and Convertibility Risk)

Currency Transaction Report (CTR)

One of the reports required under the Bank Secrecy Act (BSA) which Citicorp and all of its entities in the US must file with the Internal Revenue Service for every cash deposit or withdrawal over $10,000

Deferred Payment

See Payment, Deferred

Demand Deposit Account (DDA)

Account in which the depositor may withdraw funds when s/he wishes (on demand)

Deposit / Relending

A funding mechanism for ECA-supported export financing wherein the ECA lends to the bank which, in turn, relends to a borrower-buyer (importer)

Direct Lending

A funding mechanism for ECA-supported export financing wherein the ECA lends directly to the buyer (importer); therefore, there is no finance earning opportunity for the

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GLOSSARY

banks Direct Lending Risk

Possibility that customer obligations will not be settled on time. It occurs in such products as loans, overdrafts, credit cards, and mortgages.

Discrepancy

Any variation or difference between the requirements of the credit and what appears on the documents presented for negotiation

Document Against Acceptance (D/A Collection)

The release of title documents to the buyer upon acceptance of a time draft

Document Against Payment (D/P Collection)

The release of title documents to the buyer upon payment of a sight draft

Documentary Collections

Collection method in which the goods are shipped to the buyer, and the bank retains custody of the title documents and delivers them to the buyer when the buyer pays for the goods or commits itself for the payment

Documentation Risk

Possibility that written instruments connected to a contract or transaction are incorrect, incomplete, or unenforceable

Draft

A signed order by one party (the drawer) addressed to another (the drawee) directing the drawee to pay a specified sum of money to the order of a third person, the payee (See Bill of Exchange)

Drawdowns

Scheduled payments to be made to the borrower which are set by the lending bank

Drawee

The party on whom a bill of exchange, or draft, is drawn and from which payment is expected. The drawee may be an individual, a corporation, or a bank.

Drawer

One who signs a draft or bill of exchange (usually the seller, or beneficiary of a Letter of Credit)

EC

See “European Community”

Eligible Banker’s Acceptance

Banker’s acceptance that meets certain criteria established by the US Federal Reserve Bank so that the issuing bank

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GLOSSARY

A-7

does not have to maintain reserves against it Endorsed / Endorsement

A signature on the back of a negotiable instrument made primarily for the purpose of transferring the rights of the holder to another person

Eurodollars

Currency in US dollars deposited in a bank outside the US such as a foreign bank, an overseas bank of a US bank, or an International Banking Facility

European Community (EC)

Group of European countries that have joined together to establish a common market which assures the free movement of people, goods, services, and capital

Expiration Date

The final date upon which conforming drafts and/or documents under a Letter of Credit may be presented to a bank for negotiation or payment

Export Administration Act (EAA)

Legislation that imposes civil fines for violations of US anti-boycott laws and regulations

Export Credit Agency (ECA)

Government agency that provides preferential financing rates and terms for loans to foreign companies who buy from local exporters

Export Financing

Financing provided to the exporter (seller) for the period between shipment of goods and receipt of payment from the importer (buyer)

Export-Import Bank of the United States (EXIMBANK)

Export credit agency of the US government that provides credit support when competitive private financing is unavailable. Its programs include guarantees, insurance, and direct extensions of credit.

Exports

Goods or services that a country sells to other countries

Firm Offer

Letter confirming an indicative offer

Fixed Rate of Interest

Remains constant for the life of the financing

Floating Rate of Interest

Adjusted periodically, usually semi-annually, on dates when repayment installments of the loan principal are due

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GLOSSARY

Foreign Exchange Risk

Risk resulting from purchasing or selling goods at a price denominated in a currency other than that of the purchaser or seller

Forfaiting

Technique whereby the seller (exporter) can offer shortor medium-term financing to an overseas buyer by selling the buyer’s promissory notes, usually without recourse, at a discount to a forfaiter. The forfaiter, in turn, sells the notes in the secondary market. Also known as “a forfait.”

General Agreement on Tariffs and Trade (GATT)

Organization of over 100 member countries with a set of bilateral trade agreements created to abolish quotas and reduce tariff duties among participating nations

Guarantee

Written promise to carry out another party’s obligation in the event of default

Guaranteed Loan

Loan for which repayment is guaranteed by another party other than the borrower

Guarantor

Party who extends a guarantee

ICC

International Chamber of Commerce

Image Risk

Possibility that an activity of the bank, or one of its representatives, will damage the reputation of Citibank

Import Financing

Financing provided to the importer (buyer) so it can meet its obligations with the exporter

Imports

Goods and services that a country buys from other countries

Indicative Offer

Initial offering letter sent to a customer

Inspection Certificate

Document issued by an independent third party when an outside inspection is called for in the merchandise contract

Insurance Document

A title document indicating proof of ownership by an organization or individual with the rights to claim for compensation in the event of damage or loss of merchandise

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GLOSSARY

A-9

Interest Make-Up

A funding mechanism for ECA-supported export financing wherein the ECA compensates a lending bank for the difference between its cost of funding plus spread and the fixed interest rate on the loan to the borrower

Interest Rate

Percentage that the bank charges the customer for using borrowed funds, usually quoted on an annual basis

Interest Rate Risk

Possibility that the interest rate at which the seller borrows to cover the period between shipment of goods and receipt of funds may rise to the point where the transaction may become unprofitable

International Bank for Reconstruction and Development (IBRD)

A legal, financial entity of the World Bank which makes market-rate loans to newly industrialized countries by borrowing in the world capital markets

International Banking Facility (IBF)

Separate group of accounts set up by a US bank, or a US branch of a foreign bank, to record international banking transactions. An IBF is located in the US and may offer deposits denominated in currencies other than the dollar

International Development Association (IDA)

A legal, financial entity of the World Bank which extends assistance to the poorest developing countries on lenient terms (e.g., interest-free loans), largely from resources provided by its wealthier members


An affiliate of the World Bank, it is the world’s largest multilateral organization specifically structured to provide loans to — and equity investments in — private companies in emerging markets

International Standby Practices (ISP)

A publication by the International Chamber of Commerce (ICC) that provides guidelines for parties / participants in standby letter of credit transactions.

Inventory Financing

Financing provided to the exporter (seller) so it may hold readily marketable staples in storage and complete the sale of these staples to an importer (buyer) within the exporter’s country or overseas; the goods serve as collateral for the loan

Irrevocable

A term placed on an instrument to indicate that it can only be amended or terminated prior to its expiration

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GLOSSARY

date with the consent of each party Issuing or Opening Bank

Bank that opens (issues) the credit at the request of its customer (importer)

Know-YourCustomer Policy

Policy that requires financial institutions to monitor new and existing accounts to help identify suspicious customer activity

Legal and Regulatory Risk

Possibility that the bank may face civil, criminal, and administrative proceedings because a transaction fails to comply with all applicable laws and regulations

Lending Risk

A category of credit risk which involves extensions of credit and/or credit-sensitive products (loans and overdrafts) where the bank takes the full risk for the entire life of the transaction

Letter of Credit

A method of payment for goods or services. Instrument issued by a bank in favor of a beneficiary (seller) by which the bank substitutes its own creditworthiness for that of the applicant (e.g. buyer)

Letter of Credit, Back-to-Back

Two independent Letters of Credit used jointly to facilitate the purchase of the same goods

Letter of Credit, Commercial

A letter of credit intended as a payment method for goods or services

Letter of Credit, Confirmed

An irrevocable Letter of Credit to which another bank, usually in the country of the exporter, has added its irrevocable commitment to honor drafts and documents

Letter of Credit, Cumulative

A revolving letter of credit is cumulative when the letter of credit becomes re-available as to amount or quantity. Any portion not utilized may be accumulated for later use depending upon the wording in the Letter of Credit

Letter of Credit, Export

Letter of Credit opened by an overseas bank on behalf of an overseas importer (buyer) in favor of a local exporter as payment for local goods purchased v-2.1

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GLOSSARY

A-11

Letter of Credit, Import

Letter of Credit opened by a local bank on behalf of a local importer (buyer) in favor of an overseas exporter (seller) to secure payment for foreign goods purchased

Letter of Credit, Irrevocable

Letter of Credit that cannot be canceled or changed without the consent of the issuing bank, confirming bank (if the L/C is confirmed), and the beneficiary (seller)

Letter of Credit, Negotiable

Letter of Credit under which the issuing bank’s obligation extends to the drawer of the draft or any bona fide holder thereof

Letter of Credit, Red Clause

See “Red Clause”

Letter of Credit, Revocable

Letter of Credit that can be canceled or changed by the issuing bank at any time, without notifying or obtaining the consent of the buyer

Letter of Credit, Revolving

Letter of Credit that, by its terms, renews its value over a given period, either automatically or by amendment

Letter of Credit, Standby

A standby Letter of Credit secures a transaction or the performance of another party. A standby L/C is often used in place of performance bonds or payment guarantees.

Letter of Credit, Straight

Letter of Credit under which the issuing bank’s obligation extends only to the Beneficiary

Letter of Credit, Transferable

Letter of Credit that allows the beneficiary to transfer the credit to a second beneficiary

Letter of Guarantee

Written promise to carry out another party’s obligation in the event of default. The letter of guarantee is the Middle Eastern counterpart of a standby letter of credit

Leverage

Power in a negotiation

Leveraged Returns

Realizing greater revenue through use and management of third party liabilities (credit) in a silent syndication deal to transfer some of the risk

LIBOR

London Interbank Offer Rate, interest cost to a bank to obtain a deposit in the Eurodollar market

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v-2.1

A-12

GLOSSARY

Line of Credit

The maximum amount which a customer is entitled to borrow from a bank at any given time. This amount allows a bank’s customer to undertake several lending transactions as long as their total amount does not exceed, at any given time, the amount granted under the line of credit.

Lloyds of London

300-year old insurance association located in London

Macroeconomics

The study of the economy as a whole, as opposed to “microeconomics” which is the study of an individual firm, commodity, or consuming unit

Money Laundering

Investment or transfer of money from illegal sources into legitimate channels so that the original source of the funds cannot be traced

Money Laundering Control Act (MLCA)

US law that makes money laundering a federal crime and defines criminal offenses that are considered part of the money laundering process

Multilateral Agencies (MLAs)

Institutions established by governments whose purpose is to maintain orderly international financial conditions and to provide capital and advice for economic development, particularly in those countries that lack such resources to do it themselves. The World Bank is an example of a multilateral agency.


An affiliate of the World Bank which was established to encourage foreign direct investment in emerging market countries by providing investment guarantees and advisory services

Negotiable

A term placed on an instrument (draft, Letter of Credit, or other document) which allows the title to be transferred from owner to owner by endorsement, usually evidenced by the use of the words “order of” or “to the order”

Negotiable Instrument

Instrument such as a bill of exchange, check, or promissory note used as a payment device in international trade

Negotiating Bank

A bank, usually unnamed in the Letter of Credit, which elects to “negotiate” (purchase documents from, and advance funds to, the beneficiary) against presentation of the documents required by, and complying with, the v-2.1

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GLOSSARY

A-13

Letter of Credit terms. Negotiation may be made with or without recourse. Nonsovereign Funding

Loan made to a Citibank branch for subsequent relending to a local private borrower with an agreement that states that the branch is obliged to repay the loan / deposit unless some measure imposed by the local government prevents funds from leaving the country

Nontariff Barrier

Measure that restricts imports

North American Free Trade Agreement (NAFTA)

1994 agreement to facilitate the flow of goods and capital between the United States, Canada, and Mexico by creating a free trade zone among their territories

Offering Letter

Letter containing a structure and price proposal

Office of Foreign Assets Control (OFAC)

US Dept. of Treasury office which publishes extensive lists

Offshore Vehicle

See Vehicle, Offshore

On Consignment

A method of payment for goods where the title to goods remains with the supplier / manufacturer until they are sold by an agent or third party

Open Account

Payment method in which the seller finances the buyer by shipping the goods without receiving payment or a written promise to pay.

Open Syndication

Risk transfer technique in which the investing banks act as a consortium and are disclosed to each other and to the customer

Operational / Systems Risk

Possibility of a systems (technology) or manual error which may be internal and/or external to the bank

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of specially designated nationals, terrorists, and narcotics traffickers whose assets must be blocked, even if located outside the “blocked” country

v-2.1

A-14

GLOSSARY

Organization for Economic Cooperation and Development (OECD)

International organization of industrialized, marketeconomy countries


US government agency whose primary objective is to insure or guarantee US investment overseas in the

Packing List

Document that indicates the contents of a package being shipped

Pacto Andino

Andean Pact, a 1969 agreement among Ecuador, Colombia, Chile, Bolivia, and Venezuela to form a Latin American common market within that region

Participation

Trade financing structure with correspondent bank(s) assuming a certain percentage of Citibank’s exposure to the country and commercial risk of the borrower

Paying Bank

Bank named in the Letter of Credit as the bank which will pay, without recourse, upon receipt of documents in compliance with the Letter of Credit terms

Payment, Deferred

A Commercial Letter of Credit payable on a specified future date. The beneficiary may present the complying documents at an earlier date, but the Commercial Letter of Credit is payable only on the specified future date

Payment, Sight

A Commercial Letter of Credit is payable at sight when the beneficiary presents the complying documents and if the presentation takes place on or before the expiration of the Commercial Letter of Credit

Performance Bond

Instrument designed to ensure that the contractor (e.g., supplier) will perform and execute the contract in accordance with all its terms and conditions

Performance Risk

Possibility that an exporter may fail to perform under the contract established with the importer

emerging markets

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GLOSSARY

A-15

Political (Sovereign) Risk

Possibility that the actions of a sovereign government (e.g. nationalization or expropriation) or independent events (e.g. wars, riots, civil disturbances) may affect the ability of customers in that country to meet their obligations to Citibank

Pre-Export Financing

Financing provided to the exporter (seller) with a firm contract sale in order to acquire and prepare goods for shipment

Pre-Payment of Exports

Pre-export financing offered by Citibank Brazil for manufacturing expenses associated with goods to be exported. Funding is advanced from an offshore vehicle, the principal repaid by the importer, and interest repaid by the exporter to the funding entity.

Pre-Settlement Risk (PSR)

Possibility that a counterparty may default on a contractual obligation to the bank before the settlement date of the contract

Prime Rate

Most favorable interest rate charged by a commercial bank on short-term loans to its most creditworthy customers

Product Risk

Possibility that the structure of a trade product or service (e.g. Letter of Credit) is inadequate or faulty

Project Financing

Financing, usually provided by multilateral agencies, with the intention of bringing economic value to an importer’s country. Such financing is extended on the basis of projected cash flows instead of traditional forms of collateral. Cash flows from the financed project are expected to pay the interest and repay the principal amount which originally supported the project.

Promissory Note

A written promise committing the signer (borrower) to pay a certain amount to the payee (lender) at a future date, usually with interest

Quality Certificate

Document that verifies that the merchandise to be shipped agrees with the quality standards requested for that product

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v-2.1

A-16

GLOSSARY

Quota

Restriction on the quantity of specific products that can be imported and exported

Receivables

Amounts owed to a company

Recourse

A term used on a negotiable instrument to indicate that the drawer, or endorser, is liable to subsequent holders for payment at maturity

Red Clause

A provision in a Letter of Credit that provides for the advance of funds to the beneficiary prior to the presentation of the stipulated documents

Return on Assets

Measure of the bank’s performance in using assets to generate earnings independent of the financing of those assets

Revocable

A term placed on an instrument to indicate that it can be modified or canceled without prior agreement from each party

Risk Transfer

This strategy involves the identification and use of techniques for shifting the political and/or commercial risks of international trade

Sanctions

Economic measure adopted by one or several countries to force a nation that is violating international law to discontinue the offending behavior

Secured Loan

Loan agreement that provides security to the bank by means of pledged collateral

Security Agreement

Document which links the collateral to a loan or credit facility

Settlement Risk

Possibility that the bank will deliver funds on the settlement date of a contract, but not receive payment

Shipping Documents

Transport, commercial, and any official documents which are required by the exporter’s and importer’s countries to certify the shipment of goods

Shipping Terms

See Terms, Shipping

Sight Draft

Draft payable upon proper presentation to the drawee v-2.1

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GLOSSARY

A-17

Sight Payment

See Payment, Sight

Signature Books

Security measure used by banks to verify customers’ signatures

Silent Syndication

Risk transfer syndication in which the customer does not know that there are other investors in the transaction

Society for Worldwide International Financial Telecommunications (SWIFT)

A private international communication system used by the banks to transfer funds by wire

Southern Cone Common Market (MERCOSUR)

Agreement between Argentina, Brazil, Paraguay, and Uruguay to create a common market for the member countries

Sovereign Risk

See “Political Risk”

Specially Designated National (SDN)

Person or company considered to represent the governments of sanctioned countries

Standby Letter of Credit, Guarantee Type

Instrument that functions as a form of protection to cover performance, financial or non-financial obligation, under a contract. It protects the beneficiary in the event that the bank’s customer fails to perform under a contract which is independent of the Letter of Credit

Standby Letter of Credit, Payment Type

Instrument that serves as a payment mechanism when an underlying obligation is due, typically in connection with the repayment of money, including any instrument evidencing an obligation to repay borrowed money (e.g. promissory note)

Storage Financing

Financing provided to US sellers for the storage of readily marketable staples while their sale to US or foreign buyers is completed

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v-2.1

A-18

GLOSSARY

Supplier Credit Financing

A financing arrangement under which the supplier agrees to accept deferred payment terms from the buyer, and funds itself by discounting or selling the bills of exchange or promissory notes so created with a bank in its own country. Payment is guaranteed by an insurance policy from an export credit agency.

Surety Bond

Instrument designed to ensure financial compensation to the buyer if the supplier does not perform contractually as agreed

Syndication

Loan made by several banks or lenders that form an association to assume the responsibility and share the risks of the loan

Tariff

Tax placed on imported goods

Tenor

The length of time a bill is drawn to run before presentation for payment. The time between the date of issue or acceptance of a note or draft and the maturity date.

Term Loan

Loan with a maturity greater than one year

Terms, Payment

The terms under which a seller and buyer agree that the exchange of goods for payment shall take place. Open account, cash in advance, Letter of Credit, consignment, and documentary collection are examples of common payment terms.

Terms, Shipping

Shipping terms stating, in abbreviated form, where the seller’s responsibility for the goods ends and where the buyer’s begins; i.e. F.O.B. (Free On Board)

Test Keys

Security measure used by banks to establish authenticity of instructions from bank to bank in a correspondent relationship

Time Draft

A draft payable at a fixed or determinable future date after presentation to the drawee

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GLOSSARY

A-19

Title Document

A legal document indicating proof of ownership by an organization or individual of a certain merchandise

Trade Acceptance

A time draft drawn by the seller of goods on the buyer, and accepted by the buyer, for payment at a specified future date. In a trade acceptance, payment of the time draft is not assured by a bank.

Trade Agreement

Agreement between two or more countries concerning the buying and selling of each country’s goods and services

Trade Credit Insurance

Protects against political instability, the possibility of regional or global economic problems, and natural disasters

Transfer Risk

Possibility that a borrower is unable, due to legal or other barriers, to transfer funds in the foreign currency of payment to the place of payment when its obligation in that currency matures

Transport Document

A title document indicating proof of ownership by an individual or organization toward the merchandise described within the document; all types of documents evidencing shipment or dispatch of goods, e.g. bill of lading, air waybill

Uniform Customs and Practice for Documentary Credits (UCP)

A publication of the ICC that explains the responsibilities of merchants and bankers in the operation of Letters of Credit

Uniform Rules for Collections (URC)

A publication of the International Chamber of Commerce (ICC) that provides guidelines for parties / participants involved in collections transactions

Unsecured Loan

Loan not backed by a pledged collateral or security agreement. Unsecured loans are granted on the financial strength and reputation of the borrower.

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v-2.1

A-20

GLOSSARY

Usance Period

Length of time allowed for payment

Vehicle, Offshore

Facility used for booking international trade transactions. It is not a separate banking entity, but a separate group of accounts or bookkeeping systems set up by a US bank or a US branch of a foreign bank to record international banking transactions

Warehouse Financing

See “Inventory Financing”

Warehouse Receipt

Title document stating that a warehouse company is holding a certain quantity of a specific commodity. The company will continue to hold these goods until the warehouse receipt is exchanged for the merchandise.

Weight List

Document that indicates the total gross and net weights of the cargo

With Recourse

Term used on an instrument or endorsement to indicate that the drawer or endorser is liable to subsequent holders for payment at maturity

Without Recourse

Term used on a negotiable instrument to indicate that the drawer or endorser is not liable to subsequent holders for payment at maturity

v-2.1

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Index

Appendix B INDEX A Acceptance

2-17, 2-36, 2-37, 3-12, 3-24— 3-29, 3-32, 5-20

Acceptance Commission Rate

3-26, 3-27

Acceptance Discount Rate

3-26

Acceptor

3-24

Advising Bank

2-31, 2-34, 2-35, 2-44— 2-46, 2-52, 2-53, 2-57, 4-7, 5-14

Aging Certificate All-In Quote

5-14, 5-33, 5-34

All-In Rate

3-27, 3-45

Allocating Cross Border

3-54, 4-10, 4-11

Analysis Certificate

2-78

Applicant

2-31, 2-32, 2-34, 2-35, 2-37, 2-40, 2-42, 2-43, 2-45, 2-46, 2-48, 2-49, 2-51— 2-53, 2-56— 2-58, 3-25, 4-7, 5-15

Asociación Latino-Americana de Integración (ALADI)

1-10, 1-12, 5-14


2-39, 2-41, 2-42

Aval

3-24, 3-31— 2-33, 2-35

B Bank Secrecy Act (BSA)

4-41, 4-42

Banker’s Acceptance

2-74, 3-1, 3-23, 3-25— 3-29, 3-34, 3-36, 3-41, 3-55, 3-60, 43, 4-7, 4-8, 4-34, 4-41, 5-18

Bank-to-Bank Reimbursement

4-7, 4-8, 4-34

Basic Information Report (BIR)

4-43, 5-3

Beneficiary

2-31, 2-32— 2-49, 2-51— 2-53, 2-55— 2-58, 2-73, 3-25, 336, 3-48, 4-7, 4-14

Bid Bond

2-48, 2-55, 2-56, 2-65, 2-66, 2-69, 2-70

Bill of Exchange

2-73, 2-74, 2-78, 3-24, 3-29, 3-31, 3-33, 3-48

Bill of Lading

2-75, 2-78

Bond

2-49, 2-50, 2-54, 2-55, 2-56, 2-65, 2-66, 2-69

Boycott

4-1, 4-8, 4-33, 4-34, 4-36— 4-39, 4-43, 4-44

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v-2.1

B-2

INDEX

B (Continued) Bundled with Transactions

5-18

Buyer’s Credit Financing

3-47, 3-53, 3-54

C Cash in Advance

2-3— 2-5, 2-9, 2-18


2-77

Channels of Trade

3-27

Citicorp International Trade Indemnity, Inc. (CITI)

3-51, 3-54, 4-16, 4-19, 4-20, 4-43

Clean Risk

3-54

Commercial Interest Reference Rate (CIRR)

3-45

Commercial Invoice

2-12— 2-14, 2-75, 2-77, 2-78

Commercial Risk

1-16, 2-4, 2-5, 2-10, 2-11, 2-16, 2-17, 2-39, 2-43, 2-45, 2-51, 2-53, 3-24, 3-46, 3-51, 3-53, 3-54, 3-56— 3-60, 4-3, 4-10, 4-12, 4-13, 4-15— 4-20, 5-12, 5-14, 5-18

Compliance

2-35, 2-45, 4-1, 4-8, 4-33, 4-34, 4-39, 4-43, 4-44, 5-1

Confirming Bank

2-31, 2-32, 2-35, 2-38— 2-40, 2-44— 2-46, 2-52, 2-53, 2-57, 3-57, 5-16

Consignee

2-9— 2-11

Consignment

2-3, 2-9— 2-11, 2-18

Contingent Lending Risk

4-2, 4-3, 4-21

Contract Frustration

3-52, 4-15

Convertibility Risk

2-56, 3-3, 3-59, 4-2, 4-5, 4-6, 4-10, 4-13, 4-18, 4-21, 5-9

Correspondent Bank

2-55, 3-1, 3-55— 3-60, 5-14, 5-15

Counterparty

4-3, 4-4, 4-13

Counterparty Risk

3-8, 4-14, 4-21

Country Risk

1-13, 1-16, 2-4, 2-7, 2-9, 2-17, 2-39, 2-43— 2-45, 2-51— 2-53, 2-57, 2-58, 3-3, 3-6, 3-29, 3-34, 3-35, 3-41, 3-42, 3-44, 3-46, 3-51— 3-54, 3-56— 3-60, 4-2, 4-4, 4-5, 4-7, 4-10— 4-12, 4-15— 4-22, 4-43, 5-12, 5-14, 5-18

Country Risk Insurance

4-15, 4-43

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INDEX

B-3

C (Continued) Credit Line

3-7, 3-11, 4-11

Credit Risk

2-4, 2-5, 2-9— 2-11, 2-16, 2-42— 2-45, 2-51— 2-53, 2-57, 3-5, 3-26, 3-28, 3-29, 3-34, 3-35, 3-42, 3-46, 3-52, 4-2— 4-4, 4-7, 4-9, 4-10, 4-13, 4-15, 4-16, 4-21, 5-12

Cross-Border Risk

2-1, 2-7, 2-8, 2-10, 2-11, 2-16, 2-39, 2-57, 3-3, 4-2, 4-4— 4-6, 4-10— 4-13, 4-21, 4-43, 5-9— 5-11, 5-14, 5-25

Currency Transaction Report (CTR)

4-42

D Deferred Payment

See “Payment, Deferred”

Demand Deposit Account (DDA)

5-7

Deposit / Relending

3-43, 3-44, 3-60

Direct Lending

1-13, 3-43, 4-11

Direct Lending Risk

4-2— 4-4, 4-21

Discrepancy

2-33

Document Against Acceptance (D/A Collection)

2-14, 2-15, 3-13

Document Against Payment (D/P Collection)

2-3, 2-9, 2-12, 2-13, 2-15— 2-18, 3-24, 4-7, 4-8, 4-34, 4-41, 5-13

Documentary Collections

2-3, 2-9, 2-12, 2-13, 2-15— 2-18, 3-24, 4-7, 4-8, 4-34, 4-41, 5-13

Documentation Risk

4-2, 4-7, 4-8, 4-13, 4-21

Draft

2-6, 2-12— 2-15, 2-17, 2-37, 2-38, 2-45, 2-53, 2-73, 274, 2-78, 3-23— 3-26, 3-28, 3-31, 3-32, 3-35, 3-52, 353, 5-18

Drawdowns

3-7

Drawee

2-73, 3-24, 3-33

Drawer

2-73, 3-26

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v-2.1

B-4

INDEX

E EC

See “European Community”

Eligible Banker’s Acceptance

3-13, 3-27, 3-28

Endorsed / Endorsement

2-17, 2-49, 2-76

Eurodollars

3-4, 3-5, 3-15

European Community (EC)

1-1, 1-5— 1-7, 1-9

Expiration Date

2-32, 2-41

Export Administration Act (EAA)

4-37, 4-38

Export Credit Agency (ECA)

1-1, 1-6, 1-12, 1-13, 1-15, 1-17, 3-10, 3-23, 3-36, 3-41— 3-55, 3-60, 4-14, 4-16, 4-17, 4-22, 4-43, 5-19

Export Financing

1-13, 1-15, 3-1, 3-9— 3-13, 3-23, 3-25, 3-36, 3-41, 3-43, 3-46, 3-48, 3-50— 3-52, 3-55, 3-58, 3-60, 4-18, 5-22— 5-24

Export-Import Bank of the United States (EXIMBANK)

3-43, 3-50, 3-54, 4-17, 4-19, 4-20

Exports

1-1, 1-5, 1-6, 1-12, 1-13, 1-17, 2-7, 2-45, 3-41, 4-11, 4-16, 4-37, 5-2, 5-4, 5-7

F Firm Offer

3-32, 5-19, 5-23, 5-24

Fixed Rate of Interest

3-4, 3-5, 3-34, 3-42, 3-44, 3-45, 5-17, 5-18

Floating Rate of Interest

2-8, 3-4, 3-5, 3-44, 3-45, 5-17, 5-18

Foreign Exchange Risk

1-16, 2-7, 2-8, 2-10, 2-11, 2-16, 2-17, 2-43, 2-45, 2-51, 2-53, 257, 2-58 3-1, 3-23, 3-29— 3-36, 3-41, 3-53— 3-55, 3-59, 3-60, 4-17, 4-18, 4-22, 4-43, 5-18

Forfaiting

G General Agreement on Tariffs and Trade (GATT)

1-5, 1-10, 1-11

Guarantee

1-8, 1-11— 1-13, 1-15, 2-39, 2-47, 2-48, 2-54, 2-56, 3-24, 3-29— 3-31, 3-33, 3-35, 3-42, 3-44, 3-46— 3-48, 3-50, 3-51, 3-53, 3-54, 3-60, 4-15— 4-17, 4-22, 5-17, 5-19

Guaranteed Loan

3-6

Guarantor

3-6, 3-30, 3-35

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INDEX

B-5

I ICC

1-2, 2-18, 2-33, 2-34

Image Risk

4-2, 4-7, 4-21

Import Financing

3-11, 3-13, 3-52, 3-58, 5-10, 5-16, 5-17

Imports

1-4, 1-5, 1-12, 1-13, 2-7, 2-9, 5-2, 5-6, 5-7

Indicative Offer

5-19, 5-21— 5-24

Ineligible Banker’s Acceptance

3-27, 3-28

Inspection Certificate

2-77, 2-78

Insurance Document

2-6, 2-75, 2-76, 2-79

Interest Make-Up

3-43— 3-45, 3-50, 3-60

Interest Rate

1-13, 2-8, 3-4— 3-6, 3-14, 3-25, 3-31, 3-35, 3-42, 3-44, 3-45, 354, 3-60, 5-17, 5-22, 5-24

Interest Rate Risk

2-8, 2-16, 2-17, 3-35

International Bank for Reconstruction and Development (IBRD)

1-14

International Banking Facility (IBF)

3-4, 3-8, 3-12, 3-58, 4-6

International Development Association (IDA)

1-14


1-14, 1-15

International Standby Practices (ISP)

2-33

Inventory Financing

3-11, 3-14

Irrevocable

2-32, 2-38, 2-47— 2-49, 2-57, 3-31

Issuing or Opening Bank

2-31— 2-35, 2-37— 2-46, 2-51— 2-54, 2-57, 2-58, 4-7, 4-13, 4-38, 5-14— 5-16

K Know-Your-Customer Policy

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4-42

v-2.1

B-6

INDEX

L Legal and Regulatory Risk

3-28, 4-2, 4-7, 4-8, 4-10, 4-21, 4-33

Lending Risk

3-3, 4-2— 4-4, 4-21

Letter of Credit

2-31— 2-44, 2-46— 2-48, 2-51, 2-52, 2-56— 2-58, 2-73, 2-74, 2-76, 3-13, 3-25, 3-34, 3-56, 3-57, 3-60, 4-7, 4-13, 4-17, 4-37, 4-39, 5-5, 5-10, 5-14— 5-16

Letter of Credit, Back-to-Back

2-39— 2-41

Letter of Credit, Commercial

2-1, 2-33— 2-37, 2-39, 2-42, 2-45, 2-47, 2-58, 3-58

Letter of Credit, Confirmed

2-32, 2-38, 2-39, 2-43, 2-51, 2-57, 2-58, 3-57, 3-58, 3-61, 411, 4-13, 4-17

Letter of Credit, Cumulative

2-39

Letter of Credit, Export

2-46, 5-12

Letter of Credit, Import

2-46, 5-11, 5-14, 5-15

Letter of Credit, Irrevocable

2-32, 2-37— 2-40, 2-47— 2-49, 2-57

Letter of Credit, Negotiable

2-37, 2-38

Letter of Credit, Red Clause

See “Red Clause”

Letter of Credit, Revocable

2-32, 2-47— 2-49, 2-57

Letter of Credit, Revolving

2-39

Letter of Credit, Standby

2-1, 2-33, 2-47— 2-53, 2-56, 2-58

Letter of Credit, Straight

2-37

Letter of Credit, Transferable

2-39, 2-41, 2-42

Letter of Guarantee

2-54, 2-56, 3-33

Leverage

2-1, 2-3, 2-5, 3-54

Leveraged Returns

4-21

LIBOR

3-5, 3-44, 3-45, 5-13, 5-16— 5-18, 5-22, 5-24

Line of Credit

3-7, 3-11, 4-11

Lloyds of London

3-51, 4-16, 4-43

M Macroeconomics

1-9, 3-51

Money Laundering

4-1, 4-33, 4-34, 4-41, 4-42, 4-44

Money Laundering Control Act (MLCA)

4-41, 4-42

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INDEX

B-7

M (Continued) Multilateral Agencies (MLAs)

1-1, 1-6, 1-12— 1-15, 1-17, 3-41, 3-50, 3-51, 3-55, 3-61


1-14, 1-15

N Negotiable

2-17, 2-76, 3-28, 3-30, 3-31

Negotiable Instrument

2-17, 2-18, 2-74

Negotiating Bank

2-37, 2-38, 2-44— 2-46, 2-57, 2-74, 4-7

Nonsovereign Funding

3-57— 3-59, 3-61

Nontariff Barrier

1-3— 1-5, 1-17

North American Free Trade Agreement (NAFTA)

1-5, 1-6, 1-8

O Offering Letter

5-1, 5-19, 5-20

Office of Foreign Assets Control (OFAC)

4-35, 4-36

Offshore Vehicle

See “Vehicle, Offshore”

On Consignment

2-3, 2-9— 2-11, 2-18

Open Account

2-3, 2-4, 2-6— 2-9, 2-18, 3-13, 5-7

Open Syndication

4-14

Operational / Systems Risk

2-16, 2-18, 2-40, 2-43— 2-45, 2-52, 2-53, 2-57, 3-28, 4-2, 4-7, 4-8, 4-21

Organization for Economic Cooperation and Development (OECD)

3-49, 3-50


1-15, 1-16

v01/20/99 p02/12/99

v-2.1

B-8

INDEX

P Packing List

2-77

Pacto Andino

1-5, 1-6, 1-9, 1-10, 1-17

Participation

1-8, 3-57, 3-60, 3-61, 5-18

Paying Bank

2-31, 2-33, 2-35, 2-37, 2-40, 2-42, 2-44— 2-46, 2-52, 2-53, 257, 3-25, 3-26

Payment, Deferred

2-36, 2-67, 2-68

Payment, Sight

2-36, 2-67, 2-68

Performance Bond

2-48, 2-55, 2-56, 2-69, 2-70, 4-15

Performance Risk

4-2, 4-7, 4-9, 4-21

Political (Sovereign) Risk

2-1, 2-4, 2-5, 2-7, 3-3, 3-60, 4-2, 4-4, 4-5, 4-10— 4-12, 4-16, 4-18, 4-19, 4-21, 4-43, 5-9

Pre-Export Financing

3-11, 3-14, 3-28, 5-9, 5-10, 5-12, 5-17, 5-18, 5-21, 5-22, 524

Pre-Payment of Exports

3-12

Presettlement Risk (PSR)

4-2, 4-4, 4-21

Prime Rate

3-4, 3-5, 3-28, 5-17, 5-18

Product Risk

4-2, 4-7

Project Financing

1-15, 3-41, 3-50, 3-51, 5-23

Promissory Note

2-6, 2-73, 2-74, 2-78, 3-7, 3-29— 3-33, 3-35, 3-36, 3-48, 353, 3-58, 3-59, 5-22, 5-24

Q Quality Certificate

2-77, 2-78

Quota

1-3, 1-5, 1-11, 1-17, 4-10

R Receivables

2-43, 3-11, 3-14, 3-48, 4-15, 4-17— 4-19

Recourse

2-38, 2-53, 4-19

Red Clause

2-39, 2-40

v-2.1

v01/20/99 p02/12/99

INDEX

B-9

R (Continued) Return on Assets

4-21, 5-9, 5-10, 5-25

Revocable

2-32, 2-47, 2-49, 2-50, 2-57

Risk Transfer

3-52, 4-12— 4-14, 4-17, 4-18, 4-20, 4-21, 4-43

S Sanctions

4-1, 4-8, 4-33— 4-36, 4-39, 4-43, 4-44

Secured Loan

3-6, 3-13

Security Agreement

3-6

Settlement Risk

4-2, 4-4, 4-21

Shipping Documents

2-33, 2-47, 2-75, 2-78, 3-12, 3-33

Shipping Terms

See “Terms, Shipping”

Sight Draft

2-13, 2-49, 2-74, 3-23

Sight Payment

See “Payment, Sight”

Signature Books

3-56

Silent Syndication

4-13, 4-20, 4-21

Society for Worldwide International Financial Telecommunications (SWIFT)

4-8

Southern Cone Common Market (MERCOSUR)

1-5, 1-6, 1-9

Sovereign Risk

2-4, 3-3, 4-5, 4-10

Specially Designated National (SDN)

4-35

Standby Letter of Credit, Guarantee Type

2-47, 2-48, 2-50, 2-69, 2-70

Standby Letter of Credit, Payment Type

2-47, 2-49, 2-50, 2-69, 2-70

Storage Financing

3-13

Supplier Credit Financing

3-10, 3-11, 3-13, 3-47, 3-48, 3-50, 3-61, 4-12— 4-14, 4-20— 422, 4-43

Surety Bond

2-48, 2-50, 2-51, 2-55

Syndication

3-6, 3-8

v01/20/99 p02/12/99

v-2.1

B-10

INDEX

T Tariff

1-3— 1-5, 1-7, 1-9, 1-10, 1-11, 1-17

Tenor

3-5, 3-12, 3-27, 3-28, 4-11, 4-20, 5-5, 5-7, 5-10, 5-15, 5-16, 520, 5-22, 5-24

Term Loan

1-13, 1-16, 3-4, 3-6, 3-7

Terms, Payment

2-2, 2-3, 2-9, 2-32, 5-6, 5-8

Terms, Shipping

2-34

Test Keys

3-56

Time Draft

2-14, 2-15, 2-17, 2-37, 2-74, 3-24, 3-25, 3-36

Title Document

2-6, 2-12, 2-16— 2-18, 2-45, 2-75, 3-13

Trade Acceptance

3-24, 3-36

Trade Agreement

1-1, 1-5, 1-6, 1-10, 1-11, 1-17

Trade Credit Insurance

4-15, 4-43

Transfer Risk

2-57, 3-3, 3-4, 3-60, 4-1, 4-2, 4-5, 4-6, 4-14, 5-9

Transport Document

2-6

U Uniform Rules for Collections (URC)

2-18

Uniform Customs and Practice for Documentary Credits (UCP)

2-33

Unsecured Loan

3-6

Usance Period

3-24

V Vehicle, Offshore

3-4, 3-8, 3-12

v-2.1

v01/20/99 p02/12/99

INDEX

B-11

W Warehouse Financing

3-13

Warehouse Receipt

3-13

Weight List

2-77

With Recourse

5-5

Without Recourse

2-31, 2-37, 2-38, 3-24, 3-29, 3-30, 3-33, 4-17

v01/20/99 p02/12/99

v-2.1

Basics of Trade Services and Trade Finance Citibank

Basics of Corporate Finance Citibank

Mediaeval Trade and Finance

Mediaeval Trade and Finance

Trade Finance During the Great Trade Collapse

Trade Finance: A Pragmatic Approach

Asset Based Finance Citibank

Finance of International Trade (Essential Capital Markets)

Services Trade and Development: The Experience of Zambia (World Bank Trade and Development Series)

Trade Secrets

Skin Trade

Trade, Agriculture And Development

Migration, Trade and Peoples

Trade, Growth, and Inequality

Skin Trade

Skin Trade

Skin Trade

Skin Trade

Wicked Trade

Skin Trade

The Trade

Skin Trade

Lustrous Trade

Cogan's Trade

Geography and trade

Balance of Trade

Tricks of the Trade

Tricks of the Trade

Balance of Trade

Tricks of the Trade

Basics of Trade Services and Trade Finance Citibank

Basics of Corporate Finance Citibank

Mediaeval Trade and Finance

Mediaeval Trade and Finance

Trade Finance During the Great Trade Collapse

Trade Finance: A Pragmatic Approach

Asset Based Finance Citibank

Finance of International Trade (Essential Capital Markets)

Services Trade and Development: The Experience of Zambia (World Bank Trade and Development Series)

Trade Secrets

Skin Trade

Trade, Agriculture And Development

Migration, Trade and Peoples

Trade, Growth, and Inequality

Skin Trade

Skin Trade

Skin Trade

Skin Trade

Wicked Trade

Skin Trade

The Trade

Skin Trade

Lustrous Trade

Cogan's Trade

Geography and trade

Balance of Trade

Tricks of the Trade

Tricks of the Trade

Balance of Trade

Tricks of the Trade

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