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Bank regulations Essay

Abstract.

Letters of credit have gained popularity, with emergence of globalization.  These are financial instruments, unique in nature that are commonly used in international trade.  Letters of credit are the most convenient way of undertaking transactions over long distances, since the buyers and sellers do not trust each other.  This paper aims at analyzing the bank regulations that pertain to banks issuing letters of credit, and their effects on bank risk and fees charged to customers.

Introduction.

Letters of credit have for a long time been used to provide both mechanical and certain risk allocation.  They are instruments that banks use to promise payment to a third parties, on behalf of second parties.  According to Salacuse and Jeswald (55-63), it is an undertaking by the bank or financial institution, after a request by an account holder or itself respectively, to honor payments on behalf of the third parties, after presentation of certain documentary evidence.  The letters of credit are promises of payment upon presentation of certain documents, provided that credit terms are met.  However, it is important to note that the letters of credit are not conditional or negotiable, and that they are irrevocable.

There are several categories of letters of credit; The first is the commercial letter of credit, and these are the most commonly used.  They are used mostly during international transactions involving sale of goods.  They are convenient due to the trust issues that are common in international transactions.  The seller does not usually trust the buyer, and is not guaranteed payment after delivery of goods.

Likewise, the buyer does not trust the seller and cannot pay him or her in advance, since he or she does not have guarantee of receiving goods, either.  The option left, is for the buyer to order his or her bank, to issue a letter of credit, which is irrevocable, as the seller trusts that bank.  The seller is paid upon presenting evidence of delivery of goods, such as shipping documents, and other relevant documents that the buyer has specified.

The second category is the standby letter of credit, which is similar to commercial letters of credit, but its purpose is to compensate the seller, in the event that the buyer fails to pay.  It acts as surety that in the event that the buyer fails to honor the agreement, the bank will step in and pay.  However, commercial banks, unlike in commercial letters of credit, do not anticipate payment since they believe that their customers will pay.  In fact, according to Gao (22-24), only about 0.03% of standby credits are not honored.

Standby letters of credit are also used as forms of securities when dealing with sureties such as bonds.  Many people view the standby letter of credit as similar to a guarantee; however, there is a significant difference.  When dealing with guarantees, the guarantor examines the agreement and if he or she proves default on the agreement, that is when they are obliged to pay.   However, when dealing with standby letters of credit, the guarantor is obliged to pay, after the beneficiary presents confirming documents, regardless of proof of default of the agreement.

Other categories include the revocable letters of credit, and these can be canceled or amended by the issuer prior to presentation by the beneficiary.  The irrevocable letters of credit cannot be canceled after or amended without the consent of the beneficiary, until the expiration of the terms of credit.  Letters of credit are assumed to be irrevocable, unless otherwise stated.  Documentary letters of credit require other documents to be presented together with the draft, when payment is being paid, while clean letters of credit only require the draft to be presented, and no documents accompanying it.

U.S. banking regulations dealing with letters of credit, and the places found.

In the United States of America, there are several regulations that govern the use of letters of credit, by banking and other financial institutions.  Some are Federal regulations and govern the issue of letters of credit over the United States and international financial institutions, while others are State regulations and govern the issue of letters of credit over different States.  However, the general regulations that govern the use of letters of credit includes; the Uniform Commercial Code, Article 5, which provides a uniform scheme of statutes, that makes it popular in many states, especially after revision, in 1995.

Another set of ‘de facto laws’ that are popular with courts, in dealing with issues of letters of credit is, the Uniform Customs and Practice for Documentary Credit.  Courts may use this legislation in cases where there is an inconsistency in the Uniform Commercial Code, since it reflects the current practice in the industry.  The International Standby Practices is used to govern standby letters of credit.  Other regulations that regulate letters of credit include the United Nations Commission on International Trade Law, and Case law.  However, this paper will analyze the regulations, in totality, since letters of credit transcend national boundaries.

Features and use of letters of credit.

According to Nevitt and Nevitt (21-35), the letter of credit may only be acceptable as an asset if it fulfills the following conditions; First, it must be held under joint control, or held personally by the Commissioner.  Secondly, the letter of credit should name the Commissioner as beneficiary, should be filed and approved in the operation plan, or should be used to fund surplus or additional capital, that the Commissioner has permitted.

The captive should disclose collateral that supports the obligation to reimburse, according to the letter of credit, in the event of occurrence of a draw.  This collateral should either not include the captive’s assets, or should be accompanied by an affidavit that shows that reimbursement is not supported by assets of the insurance company of the captive.  The letter of credit should be submitted in a form that the Commissioner finds acceptable.

The letter of credit should also be clean, unconditional and irrevocable.  It should not contain any statement referring to arising of obligations of the issuer, upon reimbursement.  According to Boyd and Gertler (66-75), the letter of credit should be issued or confirmed, and drawn by qualified financial institutions of the United States.  The letter of credit should further contain an expiry and issue date, and should explain that the representative or Commissioner, only draws a sight raft, when presenting it to obtain funds.  No other document, apart from the letter of credit, is usually required under such circumstances.

Following Article 5 of the Uniform Commercial Code, the letter of credit should indicate; it is a letter of credit, it is irrevocable, and it should contain the value of credit.  It should also indicate where the documents should be presented by the seller, and identify the exact beneficiary.  It should further indicate the documents that should be presented before payment can be done, and state that payment will be done after a sight draft.

Finally, according to Apte (31-37), the letter of credit should be valid for at least one year, and should have a clause, referred to as an ‘evergreen clause’ that is used to automatically renew the letter of credit.  The only exception to this, is if, the Commissioner has been given notice, of at least ninety days, that the letter of credit will not be renewed, after it expires.  In National Surety Corporation Vs Midland bank, the bank refused to honor payment after two and a half years, stating that the credit was untimely.  The court found in favor of the beneficiary, stating that the agreement was automatically renewed after every year, hence the agreement was still valid.

Under the Uniform Commercial Code, the bank is allowed a time period, not exceeding seven business days, to analyze documents that the beneficiary presents, for payment.  In Amwest Surety Insurance Co. Vs Concord bank, the beneficiary sued the bank for wrongful dishonor.  The court found in favor of the beneficiary, since the bank did not respond to the documents presented for 15 days, and even then, it did not give sufficient reasons to warrant a dishonor.

The regulations further explain that in the event that the documents presented have a deficiency, the bank should give the beneficiary reasonable time to rectify the situation, before the expiry of the credit.  If the bank does not give such notice, the agreement is dishonored, and the defect is found to have been possible to rectify before expiration of the credit, had reasonable notice been given, the dishonor may be es-topped.

Crucial principles in dealing with letters of credit.

In governance of letters of credit in the United States, two major principles apply; the first is the principle of independence of letters of credit.  According to Arshad and Karels (77-83), in dealing with letters of credit, three agreements come into effect.  The first is the letter of credit itself, the second is the business deal between the buyer and seller, and the third is the agreement between the issuer and applicant regarding reimbursement, in cases where the money is paid.  The letters of credit are independent from the other two agreements.

In fact, the Uniform Commercial Code states that the issuer’s obligations are unaffected by existence, nonperformance, and performance of an agreement or contract, out of which the letter of agreement becomes relevant, or underlies it.  This means that breach of contract has no effect on honoring the letter of credit by the issuer.  In Eastland bank Vs Massbank for Savings, the court found in favor of the beneficiary, since issuer had dishonored the credit agreement after looking at the contents of the business transaction, which implied breach of contract.

The letter of credit is also independent of the reimbursement agreement, and the issuer must honor it regardless of whether there will be reimbursement or not.  This is relevant in cases where the applicant becomes bankrupt.  In Eakin Vs Continental Illinois National bank and Trust Company of Chicago, the Seventh Circuit Court of Appeal held in favor of the applicant, who had become insolvent. The Court held that the issuer does not have a duty to investigate the business transactions, before agreeing to honor the letter of credit.  This is according to Article 5 of the Uniform Commercial Code.

One exception to the principle of independence, occurs during forgery and fraud.  This may occur either in the letter of credit itself, or in the business transaction.  According to Mugasha (41-47), the applicant may be able to get an injunction that stops the issuer from making payment to the beneficiary.  Before the letter of credit is dishonored in such situations, the fraud must be proved to be ‘material’ before a court of law, and it should follow the principles of equity before awarding an injunction.

In Prairie State Bank Vs universal Bonding Insurance Company, the court found in favor of the issuer, since the beneficiary had made claims against a different company, from the applicant’s.  The beneficiary was found to have been trying to obtain money from false pretenses.

The second principle that is used in governing letters of credit is the strict compliance principle.  This principle states that the documents presented by the issuer or beneficiary should strictly comply with the conditions and terms of the letter of credit, before the letter is honored.  The Uniform Commercial Code states that both the documents presented, and the place and time for presentation, should comply with the terms of the letter of credit.

In fact, a court of law ruled against the beneficiary, who relied on the Postal Service for delivery of documents, and the documents arrived after expiration of the contract.  This provided a precedent where even if the beneficiary is diligent and reasonable in relying on a means of transportation of the documents, and it fails, the courts do not protect him or her from dishonor by the issuer.

Impact of regulations on risk, and assessing fees for customers, in Chase bank.

Chase bank is part of the wider JPMorgan Chase & Co., which deals with financial services and serves over ninety million clients.  JPMorgan Chase & Co. has assets worth over $1.2 trillion and operates in more than fifty countries.  It was founded in 1799 in New York, and operates both retail and wholesale operations.  In the bank’s operations, the bank or issuer of credit requires the account holders to provide security as collateral, in case the bank is forced to pay for the letter of credit.

According to Kashyap (55-59), the type of security offered to the bank varies, and is mainly dependent on the relationship between the customer and the bank.  However, the general practice is that the fees for the letter of credit is usually composed of two components; the processing fee, as well as a small percentage of the amount contained in the letter of credit.

According to Houpt (44-57), the overall effect of the letters of credit has been to increase both the credit risk and operational risk for the banks.  The credit risk occurs due to the existence of the risk that the applicant will default in reimbursing the bank, in case it pays for the letter if credit.  The operational risk, on the other hand occurs due to exposure of the bank’s operations during the credit activities.  This risk includes exposure to fraud, loss due to human errors, and others.

With the regulations in letters of credit, the bank tries to minimize its credit risk.  This is done through calculating a credit scorecard, and analyzing the risk that the customer will default on the payments.   The credit scorecard analyzes clients in terms of defaulting on loans, and formulates a model that will be used for future clients, based on the same characteristics, and clients are subsequently ranked on a credit score.

There are various techniques used in credit scoring, and they are used in different circumstances.  These techniques include hazard rate modeling, linear regression model, reduced form credit model, and others.  With such knowledge, the banks can charge higher prices for high risk customers, and lower prices for low risk customers.

Most regulations on the letter of credit reduce risks faced by banks.  This means that they complement banking activities, rather than hurt them.  There has been an increase in the use of letters of credit due to the influx of international trade.  With the advent of globalization, international trade has increased tremendously, and since the buyers and sellers do not trust each other, they are forced to engage commercial banks to issue letters of credit.

Increase in use of these instruments has led to increase in fraud, since some people want to take advantage of it.  Since the regulations allow injunctions on payment, if misrepresentation or fraud is detected, this works well for banks, by decreasing possible credit risk.  Decrease in risk faced translates to lower fees charged to customers.

However, some letter of credit regulations work against banks.  One of these regulations is one stating that the letter of credit is independent to all other agreements, including the agreement by the applicant and the issuer.  The applicant has an agreement with the issuer, in this case a bank, to reimburse any monies paid for the letter of credit.

However, some circumstances may breach the agreement, such as bankruptcy by the applicant.  In this case, the issuer, still has an obligation to pay the beneficiary, though a reimbursement will not be realized.  This is because the letter of credit is deemed to be independent of all other agreements.  This increases the risk that bank face, and it leads to increase in fees charged to customers.

This risk can be mitigated by using the ‘Export-Import bank letter of credit insurance’ for banks.  According to Campbell (98-102), this is an instrument that reduces the risks that banks face when negotiating, and confirming letters of credit, that are issued by financial institutions based in overseas markets, when dealing with export financing.  It deals with failure of foreign banks to reimburse payments made, and is resolved by insurance.

This policy applies to such letters of credit and is regulated by the Uniform Customs and Practice for Documentary Credits.  This policy however does not cover unresolved disputes between the issuing bank and the insured.  It covers losses attributed to events such as cancellation of export or import licenses, war, in-convertibility of foreign currency, insolvency of the issuing foreign bank, and the failure to reimburse or pay for other reasons.

The major challenge, according to Chase bank employees, is the current economic crisis facing the United States.  It has made banks very wary of lending money to one another.  They have also started refusing letters of credit from other banks, fearing future insolvency problems.  In fact, according to  them, there are plenty of goods that have been loaded in docks, all over the United States, but cannot be shipped due to lack of letters of credit.  This is a big blow to importers of grains and other commodities, since 90% of the trading volume in the world is done by ship.  They are however hopeful that the $700 billion being injected to the economy will help to stabilize it, and provide more sources of credit.

Conclusion.

There has been an unprecedented increase in the use of letters of credit, which can be attributed to the increase in international trade.  It is therefore important to know the difference between letters of credit, and other financial instruments used by commercial banks.  It is also important to know the regulations that govern their use, including the factors that can make a letter of credit be dishonored.  This is because a person might take an action, which may result in dishonoring of the letter of credit.  Such include late presentation of documents, when requesting payment.

The effects that these regulations have on bank risk should also be known, since they translate to either higher, or lower cost to the customers.  For instance, the regulation that states that letters of credit are independent of all other agreements, increase the risk that banks may face, due to cases of insolvency of the applicant, thereby increasing the fees charged to customers.  However, the major problem currently facing the banking industry is the mortgage crisis, and its impact has been seen to affect issuance of letters of credit.  This problem should be resolved before it spreads to all sectors of the economy.

Works Cited.

Apte, Peter, International Financial Management. Washington: McGraw-Hill, 2006.

Arshadi, Nasser, & Karels, Gordon, Modern Financial Intermediaries and Markets. New York:

Prentice Hall, 1997.

Boyd, John, & Gertler, Martin, US commercial banking: Trends, cycles and policy. NBER  

Working Paper, Retrieved on October 22, 2008 from <papers.ssrn.com>, 1999.

Campbell, Dennis, Remedies for international sellers of goods. Retrieved on October 22, 2008

from <Lulu.com>, 2006.

Gao, Xiang, The Fraud Rule in the Law of Letters of Credit: A Comparative Study. Washington:

Kluwer Law International, 2002.

Houpt, John, International activities of US banks and in US banking markets. Federal Reserve

Bulletin, Retrieved on October 22, 2008 from < HeinOnline.com>, 2001.

Kashyap, Andrew, Monetary policy and bank lending. Journal of Monetary Policy. Retrieved on

October 22, 2008 from <books.google.com>, 2000.

Mugasha, Agasha, The Law of Letters of Credit and Bank Guarantees. Chicago: Federation

Press, 2003.

Nevitt, Peter, & Nevitt, Frank, Project Financing. Atlanta: Euromoney Books, 2000.

Salacuse, Jeswald, Code of Federal Regulations: Containing a Codification of Documents of  

General Applicability and Future Effect

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