Letter of Credit Vs. Cash Collateral

Doing domestic and international business requires a complex credit system for buying and selling. Companies want guarantees of cash or lines of credit to pay for orders. Firms ordering goods also want guarantees that businesses offering goods will supply the goods. Letters of credit and cash collateral offer forms of guarantees for both producers and buyers.

Lenders, typically commercial banks, issue letters of credit as part of sophisticated business purchasing operations. Letters of credit put the signer on the hook to pay the bill on behalf of the firm placing the order. The bank endorsement increases the value of the credit letter in the eyes of the company receiving the order. When the company delivers the goods according to the terms of the contract, the bank pays the bill. The company making the order then repays the bank for the goods, as well as a fee for the letter-of-credit service.

Lenders qualify the borrower before issuing a letter, and companies typically receive the letters from the bank providing regular financial services for the business. The advantages of a commercial letter include regulation by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits controlling the terms of the letter of credit and the payment procedure.

Standby letters of credit are documents used to show a company has the financial means to pay for an order. If the business requesting the order fails to pay the bill, the bank issuing the letter of credit then accepts responsibility for paying for the order. Standby letters have a time limit for use and come under the same regulations as standard credit letters.

Standby letters also require the same qualifying procedures as regular credit letters, even though there is less likelihood the bank ends up with the financing duties. A standby letter from a bank with an international reputation passes the credibility onto the company making the order.

Cash and items quickly converted into cash qualify as cash collateral. Certificates of deposit, bonds and securities are forms of cash collateral. Companies fill purchase orders for large firms and international corporations based on cash collateral, but small firms without a credit history have little chance to fill an order based only on goodwill and reputation. Tying up cash as collateral for orders, or converting collateral into cash, restricts the liquidity needed to operate a small company.

Lenders occasionally ask new companies to put up cash collateral for a letter of credit or a loan to purchasing inventory or raw materials. Firms working with a new bank or financial institution also face demands for cash collateral. Asking for the collateral allows the lender to collect the debt should the company fail to pay for the ordered goods. Once the new firm develops a history of prompt payment to vendors, the lender may no longer ask for the cash collateral requirement when supplying a letter of credit.