Standby Letter of Credit (SLOC)

A standby letter of credit (SLOC), also called a standby bank letter of credit (SBLC), is a bank-issued guarantee that a beneficiary will be paid if the applicant (the bank’s client) fails to meet a contractual obligation. The bank pays only when the applicant defaults or cannot perform, making the SLOC a backstop rather than a primary payment method.

How it works

• Applicant (buyer/contractor) asks its bank to issue an SLOC in favor of a beneficiary (seller/project owner).
• The issuing bank assesses the applicant’s credit and may require collateral or a cash margin.
• If the applicant fails to meet contractual terms, the beneficiary presents required documents to the bank.
• The bank reviews the documents and, if they comply with the SLOC terms, pays the beneficiary.
• After payment, the bank seeks reimbursement from the applicant or uses posted collateral.

SLOCs are highly documentary — strict compliance with the letter’s terms is required. Minor errors (e.g., misspellings, incorrect dates) can be grounds for refusal.

Types

• Financial SLOC: Guarantees payment for goods or services (common in large purchases or international trade).
  Example: An oil refiner uses a financial SLOC to assure a crude-oil seller it can pay for a large shipment.
• Performance SLOC: Guarantees project completion or performance under a contract.
  Example: A client uses a performance SLOC to protect against a contractor who fails to complete construction.

When to use an SLOC

• International trade or large, unfamiliar transactions where counterparty risk is significant.
• Construction and project contracts requiring assurance of completion or payment.
• When a buyer wants to avoid upfront payments or when a small firm needs to strengthen a bid.
• Any situation where one party needs a reliable guarantee that obligations will be met.

Benefits

• Reduces counterparty risk — the beneficiary has a bank guarantee of payment.
• Increases credibility for bidders and smaller firms competing for contracts.
• Can avoid the need for large upfront payments.
• Provides recourse if a counterparty becomes insolvent or defaults.

Costs and lender requirements

• Fees typically range from about 1% to 10% of the guaranteed amount per year, depending on applicant credit, amount, and risk.
• Banks perform credit underwriting similar to a loan review and may demand collateral or intercompany guarantees.
• The SLOC creates a contingent liability for the applicant and can affect borrowing capacity.

Limitations and risks

• Strict documentary compliance — technicalities can cause payment denial.
• Banks will pay only on presentation of the exact documents required by the SLOC.
• Costs and collateral requirements can be significant for weaker credits.
• Potential for fraud if documents are falsified; beneficiaries should still perform due diligence.

How to obtain one (summary process)

1. Request issuance from a commercial bank that offers trade finance.
2. Submit financial statements and supporting credit information.
3. Negotiate terms with the beneficiary (amount, expiry, required documents).
4. Bank underwrites risk, sets fees and collateral terms, and issues the SLOC.
5. Beneficiary presents compliant documents to claim payment if required.

Key takeaways

• An SLOC is a bank guarantee that protects beneficiaries if an applicant defaults.
• It is commonly used in international trade and large contracts to reduce payment and performance risk.
• Fees and underwriting requirements vary; banks require strict documentary compliance.
• While valuable for risk mitigation and credibility, SLOCs carry costs and procedural risks that applicants and beneficiaries must manage.

Bottom line

A standby letter of credit is a widely used tool for assuring payment or performance in high-value and cross-border transactions. It shifts credit risk from the counterparty to a bank, but requires careful drafting, documentary precision, and an understanding of fees and collateral implications.