What Is a Standby Letter of Credit (SLOC)?

A standby letter of credit is a bank's commitment of payment to a third party in the event that the bank's client defaults on an agreement. It is a "standby" agreement because the bank will have to pay only in a worst-case scenario.

A SLOC is most often sought by a business to help it obtain a contract. There are two main types of SLOC:

  • A financial SLOC guarantees payment for goods or services as specified by an agreement. An oil refining company, for example, might arrange for such a letter to reassure a seller of crude oil that it can pay for a huge delivery of crude oil.
  • The performance SLOC, which is less common, guarantees that the client will complete the project outlined in a contract. The bank agrees to reimburse the third party in the event that its client fails to complete the project.

[Important: Small businesses can have difficulty competing against bigger and better-known rivals. A SLOC can add credibility to its bid for a project.]

The procedure for obtaining a SLOC is similar to an application for a loan. The bank issues it only after appraising the creditworthiness of the applicant.

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Letter of Credit

Thus, the recipient of a standby letter of credit is assured that it is doing business with an individual or company that is capable of paying the bill or finishing the project. In the worst-case scenario, if a company goes into bankruptcy or ceases operations, the bank issuing the SLOC will fulfill its client's obligations.

The client pays a fee for each year that the letter is valid. Typically, the fee is 1% to 10% of the total obligation per year.

Advantages of the SLOC

Small businesses can have difficulty competing against bigger and better-known rivals. A SLOC can add credibility to its bid for a project.

The SLOC is often seen in contracts involving international trade, which tend to involve a large commitment of money and have added risks.

For the business that is presented with a SLOC, the greatest advantage is the potential ease of getting out of that worst-case scenario. If an agreement calls for payment within 30 days of delivery and the payment is not made, the company can present the SLOC to the buyer's bank for payment. If a contract calls for the construction of a building and the builder fails to deliver, the client presents the SLOC to the bank to be made whole.

Key Takeaways

  • A SLOC is a bank's commitment of payment to a third party in the event that the bank's client defaults on an agreement.
  • The process of obtaining a SLOC is similar to a loan application.
  • The recipient of a standby letter of credit is assured that it is doing business with an individual or company that is capable of paying the bill or finishing the project.