Trade Finance in Banking: A Comprehensive Overview
Documentary business is an integral part of the foreign operations of financial institutions. The primary objective of trade finance is to mitigate the risks associated with international trade transactions between domestic companies and their foreign counterparts. This involves the facilitation of goods and services across national borders. From a German perspective, the main reasons for engaging in international trade include outsourcing aspects, as products can be procured more cost-effectively abroad than domestically. In addition, the scarcity of specific resources or goods (e.g., bananas) plays a significant role in promoting foreign trade. On the export side, accessing new markets is a primary driving factor.
This overview introduces several key mechanisms used in global trade, including:
- Export Letters of Credit: A widely used financial instrument that provides a secure payment method for both exporters and importers by involving banks as intermediaries.
- Export Collection: A method for settling international trade transactions, in which the exporter’s bank collects payment from the importer’s bank on behalf of the exporter.
- Foreign Guarantees: Different types of guarantees, such as direct payment guarantees and other types of guarantees provided by the exporter to secure the importer, can help minimize risks in international trade.
- Export Credit Insurance: Insurance policies that protect exporters and banks involved in trade financing from non-payment risks by providing coverage for outstanding receivables.
- Forfaiting: A financial service where banks or financial institutions purchase claims from exporters without recourse, transferring economic and political risks to the purchasing entity.
- Supplier Credit: A form of financing in which the exporter provides the importer with a deferred payment option, thus taking on the role of a creditor.
- Buyer Credit: A financing arrangement where banks lend directly to the foreign importer, foreign bank, or government organization, allowing the exporter to avoid recording open receivables on their balance sheet and not burdening their credit lines.
Understanding these financial instruments and insurance policies can help businesses navigate the complexities of international trade and ensure successful transactions.
Risks in International Trade
Exporters face several risks in international trade, including the risk of the foreign buyer (importer) not accepting the goods (acceptance risk) or not being willing or able to pay (del credere risk/payment default risk). There are also political risks, such as war, payment embargoes, or foreign exchange shortages (country risk). For exporters, sea transport is generally recommended, as it enables the creation of “tradition papers” that grant access to the goods at the destination.
On the other hand, importers bear the risk of not receiving the goods on time or at all (delivery risk) and the risk of receiving goods of inferior quality (quality risk).
Country risks include conversion prohibition, transfer prohibition, payment prohibition, and moratorium.
To address the concerns of both parties, banks offer trade finance solutions that use the documents generated during the transportation process as proof of shipment.
Documents in Trade Finance
- Goods’ Documents (Transport & Storage)
These documents include the Bill of Lading (B/L) or other transport documents that serve as tradition papers, meaning that the transfer of the document results in the transfer of ownership. Such documents are bearer papers that entitle the holder to receive the goods upon presentation.
Other non-traditional goods documents (evidence documents) include shipping documents that specify a particular recipient, such as (CMR-/Air-/Rail-) freight bills or postal delivery slips.
Insurance Documents
Transport insurance covers damages that may occur during the delivery of goods. The insurance policy or insurance certificate serves as proof of this protection. It is common to take out policies for 110-120% of the goods’ value to cover any additional expenses in the event of sudden damage.Trade and Customs Documents
A commercial invoice containing information about the underlying transaction is issued. Customs documents, such as a consular invoice and/or a customs invoice, are also prepared. Additional documents include a packing list, a certificate of origin (if applicable), license evidence (if applicable), and a certificate of quality (if applicable).Accompanying Documents
Further accompanying documents may include drafts (bills of exchange) issued to the exporter but not yet signed by the debtor (importer). Once signed, the bill of exchange is called an acceptance.
The Export Letter of Credit
The export letter of credit (LC), also known as a documentary credit, is a financial instrument used in international trade to facilitate and secure transactions between exporters and importers. It is a critical tool for managing risk, ensuring timely payment, and building trust between trading partners from different countries.
How an Export Letter of Credit Works
Agreement between the importer and exporter: The process begins when the importer (buyer) and the exporter (seller) agree to use an export letter of credit for their transaction. The terms and conditions, such as the amount, shipment details, and documents required, are specified in the sales contract.
Issuance of the letter of credit: The importer then requests their bank, known as the issuing bank, to issue a letter of credit in favor of the exporter. The issuing bank will evaluate the importer’s creditworthiness and may require collateral or other guarantees.
Advising the letter of credit: Once the issuing bank approves the LC, it is sent to the exporter’s bank, known as the advising bank. The advising bank verifies the authenticity of the LC and informs the exporter of its receipt.
Shipment of goods: The exporter proceeds to ship the goods as per the terms and conditions outlined in the LC. They must also prepare and collect all required documents, such as invoices, bills of lading, and certificates of origin, to present to their advising bank.
Presentation of documents: The exporter presents the required documents to the advising bank, which verifies their compliance with the LC terms. If the documents are in order, the advising bank forwards them to the issuing bank.
Payment: Upon receipt and verification of the documents, the issuing bank releases the payment to the advising bank, which then forwards the funds to the exporter. The issuing bank then seeks reimbursement from the importer.
Release of documents: The importer receives the documents from their bank and uses them to clear customs and take possession of the goods.
Advantages of an Export Letter of Credit
Reduced risk: The LC reduces the risk of non-payment for the exporter, as the issuing bank guarantees payment as long as the terms and conditions are met.
Financing options: Exporters may use confirmed LCs as collateral to obtain pre-shipment or post-shipment financing from their banks, thus improving cash flow.
Enhanced trust: The involvement of banks in the transaction helps build trust between the trading partners, particularly when they have not worked together before or are located in different countries.
Flexibility: LCs can be tailored to suit the specific needs and requirements of the parties involved in the transaction.
In conclusion, the export letter of credit is an indispensable tool for international trade, offering security and trust for both exporters and importers while reducing the risk of non-payment. It ensures a smooth transaction process and enables businesses to expand their reach into new markets.
The Export Collection
The export collection, also known as documentary collection, is an effective instrument in international trade used to facilitate and secure payment transactions between exporters and importers. Unlike a letter of credit, an export collection does not provide a payment guarantee but is a payment term based on the principle of document delivery against payment or commitment to pay.
How the Export Collection Works
Agreement between importer and exporter: The parties agree in the contract that payment will be processed through export collection. Conditions such as the amount, delivery, and required documents are determined.
Shipment of goods: The exporter ships the goods according to the agreed-upon conditions and prepares the necessary shipping documents, such as invoices, bills of lading, and certificates of origin.
Submission of documents to the bank: The exporter submits the shipping documents to their bank, which acts as the remitting bank. The bank checks the documents for compliance with the contract terms.
Collection order: The remitting bank receives a collection order from the exporter, which contains the conditions for forwarding the documents to the importer’s bank (collecting bank).
Forwarding of documents: The remitting bank sends the documents along with the collection order to the importer’s collecting bank.
Payment or commitment to pay: The collecting bank informs the importer about the receipt of the documents and requests payment or a commitment to pay according to the conditions of the collection order. Once the importer has made the payment or committed to pay, the collecting bank hands over the documents to the importer.
Forwarding of payment: The collecting bank forwards the payment to the remitting bank, which in turn transfers the payment to the exporter.
Advantages of Export Collection
Simplicity and cost savings: Compared to a letter of credit, export collection is less complex and generally more cost-effective.
Security: By involving banks and delivering documents against payment, a certain level of security is ensured.
Flexibility: Export collection can be adapted to the specific needs and requirements of the parties involved.
In conclusion, export collection is an effective instrument in international trade that fosters security and trust between exporters and importers. It enables smooth transaction processing and supports businesses in expanding their operations internationally.
Foreign Guarantee
An additional form of securing international trade is the foreign (payment) guarantee.
The exemplary process of a direct payment guarantee:
- The importer must request the direct payment guarantee from their principal bank. This bank now acts as the guarantor and makes payment upon the exporter’s demand.
- Typically, this instrument is used when the contractual parties have negotiated a payment deadline.
The advantage of a guarantee compared to a letter of credit is that the bank commission is lower, making it more suitable for frequently recurring or smaller transactions.
Besides the payment guarantee, there are also guarantees provided by the exporter to secure the importer:
- Performance Guarantee (Contract Fulfillment Guarantee)
- Bid Bond Guarantee
- Advance Payment Guarantee
- Warranty Guarantee
In addition, indirect guarantees (counter-guarantees) are possible, in which a correspondent bank abroad also issues a guarantee that serves as a liability. If the guaranteeing bank (guarantor) does not pay, the foreign bank must now cover the damage.
Export Credit Insurance
Export credit insurance, or ECA coverage (Export Credit Agencies), protects outstanding receivables from international trade transactions, safeguarding exporting companies or banks involved in trade financing.
Export credit insurers are private companies. In Germany, EULER HERMES AG and PricewaterhouseCoopers AG (PWC) hold the federal mandate, enabling them to issue government-backed coverage on behalf of and for the federal government.
Export credit insurance covers the export risk, which represents the monetary claim after goods shipment, in the form of export credit guarantees. These include:
- Export guarantees (for transactions with private trading partners)
- Export bonds (for transactions with public/government trading partners)
Coverage recipients can be German companies (in the case of supplier credits) and banks (in the case of buyer credits). Single coverage for one-time transactions or blanket coverage for recurring transactions are possible. Other special coverage forms also exist.
Fees for Hermes coverage depend on various country and buyer categories, which assign a risk to the transaction. Coverage recipients must always provide a percentage deductible.
Forfaiting
Forfaiting is the non-recourse purchase of receivables from international trade by forfaiters (banks and financial institutions). These receivables must be due at a later date to be purchased at a discount. A repurchase by the original holder of the receivable is not possible (non-recourse).
By purchasing the receivables, the bank assumes all economic and political risks from the transaction. This purchase can take place on the primary market (directly from the customer) and on the secondary market (indirectly from other banks).
Open receivables with a payment deadline can be forfaited:
- Book receivables from supply contracts
- Promissory notes (issued by the buyer)
- Bills of exchange/Acceptance: drawn bills (issued by the seller and accepted by the buyer)
- Receivables from documentary business
- Receivables from abstract guarantees
Forfaiting costs
The costs of forfaiting result from interest costs, which arise from refinancing. The receivables amount is discounted at a present value over the term and then paid out minus a bank margin.
The basis for calculating interest is the French interest calculation (Euro method).
Advantages for the Exporter
Through forfaiting, the exporter can relieve their balance sheet and convert open receivables into liquidity. In doing so, they also transfer all risks associated with the transaction to the forfaiter. Furthermore, companies no longer have to manage the settlement of open receivables, which represents a workload relief for both small and large enterprises.
Supplier Credits
Supplier credit is a payment deadline granted by the exporter to the importer. Typically, this instrument requires an existing business relationship between the two trading partners, as a payment deadline is associated with default risks.
The exporter assumes the role of the lender and agrees on a separate financing contract with the importer. This contract also includes an interest rate for financing costs. This rate is usually higher than the market-standard bank interest rate, as the exporter may have to refinance themselves at this bank rate and add a margin.
In international trade, deferred payment letters of credit are also common, which act as supplier credit with a payment deadline.
Since open receivables have a negative impact on the exporter’s balance sheet, this type of transaction does not always make sense for them. To take on fewer risks, supplier credit can be secured with ECA coverage.
Buyer Credits
Banks grant buyer credits directly to the foreign importer, the foreign bank, or a government organization in the other country. This credit serves to settle the monetary claim from the international trade transaction.
Buyer credits are becoming increasingly important, as they do not require the exporter to record open receivables on their balance sheet and do not burden their credit lines. In particular, compared to supplier credit, it may be more advantageous to have an experienced bank negotiate credit terms with the importer, as they possess more extensive expertise.
With Hermes coverage, the risks of the transaction for the bank can be reduced.
