letters of credit and supply chain finance

1 November 2009

The letter of credit is a tool that has been in use for centuries and in its most secure form allows for trade between firms who are not in a position to understand or take the credit risk of trading together on open account.

They can be used to raise finance if, following a shipment, the seller chooses to discount the future certain cash flow that will flow from the letter of credit.

Estimates suggest that only about 10% of global trade is financed this way and the confidence and low credit risk environment of the mid 2000s suggests that this had fallen to a low. However, one estimate shows that demand for letters of credit has increased by 15% on a year ago, suggesting that firms do need to find more ways of trading in a high credit risk environment. During the credit crunch, finding letters of credit became difficult as banks exposure to other banks limited the risk that they could take on each other, as such exposure is a crucial part of the process.

Banks have been keen to push other products in this area, such as invoice financing and this has risen to record highs in recent years. Invoice financing can carry out a similar role to letters of credit, achieved by selling the invoice after shipment of goods. For SMEs (Small and medium sized enterprises) this can be the only way to achieve finance. These products can be high margin for banks and they can be expected to push them ahead of other products, such as loans.

Some firms are also changing their approach to the amount of credit given on open account or in more formalised structures. Many types of firms have financed their customers for years (hence e.g. the creation of GE Capital and GMAC) and this idea is now cascading down to many different types of firm, either on the supplier or customer side.
Treasurers need to be imaginative in this area, be aware of the cost of some of these products but also aware of the huge potential of investing in the supply chain to increase profitability of their firm.