Basics of Trade Services and Trade Finance January 1999

Basics of Trade Servicesand Trade FinanceJanuary 1999

Global Corporate BankTraining and Development

Asia Pacific

Basics of Trade Servicesand Trade Finance

Warning

This workbook is the product of, andcopyrighted by, Citibank N.A. It is solely forthe internal use of Citibank, N.A., and maynot be used for any other purpose. It isunlawful to reproduce the contents of thesematerials, in whole or in part, by anymethod, printed, electronic, or otherwise; orto disseminate or sell the same without theprior written consent of Global CorporateBank Training and Development – LatinAmerica, Asia / Pacific and CEEMEA.

Please sign your name in the space below.

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Table of Contents

TABLE OF CONTENTS

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TABLE OF CONTENTS

Introduction

Overview...................................................................................................................ix

Course Objectives.....................................................................................................ix

The Workbook ......................................................................................................... x

Unit 1: The Trade Environment

Introduction ............................................................................................................ 1-1

Unit Objectives....................................................................................................... 1-1

Overview................................................................................................................ 1-2

Political Issues............................................................................................ 1-2

Business Issues ......................................................................................... 1-3

Social Issues .............................................................................................. 1-3

Legal Issues ............................................................................................... 1-3

Factors That Restrict Global Trade ........................................................................ 1-3

Tariffs ......................................................................................................... 1-4

Nontariff Barriers ........................................................................................ 1-4

Quotas........................................................................................................ 1-5

Factors That Promote Global Trade....................................................................... 1-5

Trade Agreements...................................................................................... 1-6

European Community .................................................................... 1-6

North American Free Trade Agreement (NAFTA)........................... 1-8

MERCOSUR................................................................................... 1-9

Pacto Andino (Andean Pact) ........................................................ 1-10

Trade Agreements / Organizations........................................................... 1-10

General Agreement on Tariffs and Trade (GATT) ........................ 1-11

Asociación Latino-Americana de Integración (ALADI) .................. 1-12

Export Credit and Multilateral Agencies.................................................... 1-12

Export Credit Agencies (ECAs)..................................................... 1-13

Multilateral Agencies..................................................................... 1-13

World Bank Group ............................................................... 1-14

World Bank Affiliates ............................................................ 1-15

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Unit 1: The Trade Environment (Continued)

Overseas Private Investment Corporation (OPIC) ............... 1-15

Regional Development Banks .............................................. 1-16

Unit Summary ...................................................................................................... 1-17

Progress Check 1 ................................................................................................1-19

Unit 2: Trade Services

Introduction ............................................................................................................ 2-1

Unit Objectives....................................................................................................... 2-1

Establishing Terms Between Buyers and Sellers................................................... 2-2

Payment Options ................................................................................................... 2-3

Cash in Advance ........................................................................................ 2-4

Open Account ............................................................................................ 2-6

On Consignment ........................................................................................ 2-9

Documentary Collections.......................................................................... 2-12

Advantages and Risks to the Buyer, Seller, and Citibank............. 2-15

Summary.................................................................................................. 2-18

Progress Check 2.1 ............................................................................................. 2-19

Letters of Credit (L/C) .......................................................................................... 2-31

Parties to a Letter of Credit ...................................................................... 2-31

Revocable or Irrevocable Letter of Credit................................................. 2-32

Basic Letter of Credit Components .......................................................... 2-32

Commercial and Standby Letters of Credit .......................................................... 2-33

Commercial Letters of Credit.................................................................... 2-34

Settlements Under a Letter of Credit ............................................ 2-36

Types of Irrevocable Commercial Letters of Credit ....................... 2-37

Special Features of Commercial Letters of Credit ........................ 2-39

Advantages and Risks of Commercial Letters of Credit................ 2-42

Import Letter of Credit and Export Letter of Credit........................ 2-46

Standby Letters of Credit ......................................................................... 2-47

Standby Letter of Credit: Guarantee Type................................... 2-48

Standby Letter of Credit: Payment Type...................................... 2-49

Advantages and Risks of Standby Letters of Credit ..................... 2-51

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Unit 2: Trade Services (Continued)

Other Legal Forms of Guarantee ............................................................. 2-54

Summary.................................................................................................. 2-56

Progress Check 2.2 ............................................................................................. 2-59

Financial and Commercial Transaction Documents ............................................. 2-73

Financial Documents................................................................................ 2-73

Check ........................................................................................... 2-73

Draft / Bill of Exchange ................................................................. 2-73

Promissory Note ........................................................................... 2-74

Commercial Documents ........................................................................... 2-75

Commercial Invoice ...................................................................... 2-75

Bill of Lading ................................................................................. 2-75

Insurance Document / Policy ........................................................ 2-76

Other Documents.......................................................................... 2-77

Unit Summary ...................................................................................................... 2-78

Progress Check 2.3 ............................................................................................. 2-81

Unit 3: Trade Finance

Introduction ............................................................................................................ 3-1

Unit Objectives....................................................................................................... 3-1

Extension of Credit ................................................................................................ 3-2

Establishing Creditworthiness .................................................................... 3-2

Identifying Risks ......................................................................................... 3-3

Setting Interest Rates................................................................................. 3-4

Establishing Credit Terms .......................................................................... 3-5

Determining the Type of Financing ............................................................ 3-6

Short Term Loan............................................................................. 3-7

Medium Term Loan......................................................................... 3-7

Line of Credit .................................................................................. 3-7

Syndication ..................................................................................... 3-8

Booking Transactions................................................................................. 3-8

Managing the Credit ................................................................................... 3-9

Purposes for Trade Financing................................................................................ 3-9

Unit 3: Trade Finance (Continued)

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Pre-Export Financing................................................................................ 3-11

Export Financing ...................................................................................... 3-13

Import Financing....................................................................................... 3-13

Inventory (Warehouse) Financing ............................................................ 3-13

Summary.................................................................................................. 3-14

Progress Check 3.1 ............................................................................................. 3-15

Types of Export Financing ................................................................................... 3-23

Commercial Financing.............................................................................. 3-23

Banker’s Acceptance .................................................................... 3-25

Application of Bankers’ Acceptances ................................... 3-25

Pricing .................................................................................. 3-26

Eligible and Ineligible Banker’s Acceptance ......................... 3-27

Risks .................................................................................... 3-28

Forfaiting....................................................................................... 3-29

Advantages of Forfaiting ...................................................... 3-34

Disadvantages of Forfaiting ................................................. 3-35

Required Documentation ..................................................... 3-35

Summary.................................................................................................. 3-36

Progress Check 3.2 ............................................................................................. 3-37

Types of Export Financing (Continued) ................................................................. 3-41

Export Credit Agency-Supported Financing ............................................. 3-41

ECA Guarantee and Insurance ............................................ 3-42

Cash Payment Requirement......................................................... 3-42

Sourcing from Multiple Countries .................................................. 3-42

Local Costs Financing .................................................................. 3-43

Funding Mechanisms.................................................................... 3-43

Interest Rates: Floating and Fixed ............................................... 3-44

Insurance Coverage ..................................................................... 3-46

Transaction Structures: Buyer Credit and Supplier Credit ............ 3-47

Buyer’s Credit Financing ...................................................... 3-47

Supplier’s Credit Financing .................................................. 3-48

Multilateral Agency (MLA)-Supported Financing........................... 3-50

Unit 3: Trade Finance (Continued)

Private Insurance-Supported Financing ................................................... 3-51

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Export Finance: Structuring the Deal .................................................................. 3-52

Option One – Buyer’s Credit Combined with Insuranceor ECA Guarantee ........................................................................ 3-54

Option Two – Forfait Market ......................................................... 3-54

Summary.................................................................................................. 3-55

Correspondent Banking ....................................................................................... 3-55

Relationship Among Banks ...................................................................... 3-56

Products ................................................................................................... 3-56

Letter of Credit Confirmation......................................................... 3-57

Nonsovereign Funding.................................................................. 3-57

Participations ................................................................................ 3-59

Unit Summary ...................................................................................................... 3-60

Progress Check 3.3 ............................................................................................. 3-63

Unit 4: Risk and Compliance

Introduction ............................................................................................................ 4-1

Unit Objectives....................................................................................................... 4-1

Risks for the Bank.................................................................................................. 4-2

Credit Risk.................................................................................................. 4-3

Lending Risk ................................................................................... 4-3

Counterparty Risk ........................................................................... 4-3

Country (Political and Cross-Border) Risk .................................................. 4-4

Political (Sovereign) Risk ................................................................ 4-5

Transfer Risk .................................................................................. 4-5

Convertibility Risk ........................................................................... 4-6

Other Risks................................................................................................. 4-7

Image Risk...................................................................................... 4-7

Product Risk ................................................................................... 4-7

Operational / Systems Risk............................................................. 4-8

Legal and Regulatory Risk.............................................................. 4-8

Documentation Risk........................................................................ 4-8

Unit 4: Risk and Compliance (Continued)

Performance Risk ........................................................................... 4-9

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Risks in a Trade Finance Transaction ........................................................ 4-9

Risk Management ................................................................................................ 4-10

Allocating Cross-Border Risk.................................................................... 4-10

Risk Transfer ....................................................................................................... 4-12

Risk Transfer Through Syndication .......................................................... 4-12

Investors in Risk Transfer Transactions ................................................... 4-14

Banks............................................................................................ 4-14

Insurance Companies ................................................................... 4-14

Export Credit Agencies (ECAs)..................................................... 4-16

Other Investors – Forfaiting .......................................................... 4-17

Example of Risk Transfer / Risk Management.............................. 4-18

Option One........................................................................... 4-19

Option Two........................................................................... 4-19

Option Three ........................................................................ 4-20

Advantages of Risk Transfer .................................................................... 4-20

Summary ............................................................................................................. 4-21

Progress Check 4.1 ............................................................................................. 4-23

Compliance Issues............................................................................................... 4-33

US Sanctions ........................................................................................... 4-34

Sanction Administration in the US ................................................ 4-35

Reporting Requirements ............................................................... 4-36

Penalties....................................................................................... 4-36

US Anti-Boycott Laws and Regulations.................................................... 4-36


Penalties....................................................................................... 4-37

Discovering Noncompliance Issues .............................................. 4-38

US Export Controls................................................................................... 4-39


Penalties....................................................................................... 4-40

Anti-Money Laundering ............................................................................ 4-41

The Money Laundering Process ................................................... 4-41

Unit 4: Risk and Compliance (Continued)


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Avoiding Problems........................................................................ 4-42

Unit Summary ...................................................................................................... 4-43

Progress Check 4.2 ............................................................................................. 4-45

Unit 5: Identifying Customers’ Needs and Pricing Solutions

Introduction ............................................................................................................ 5-1

Unit Objectives....................................................................................................... 5-1

The Information Gathering Process ....................................................................... 5-2

Existing Customers .................................................................................... 5-2

New Customers.......................................................................................... 5-3

Key Pricing Benchmarks........................................................................................ 5-9

Minimum Return on Cross-Border Risk ...................................................... 5-9

Expected Return on Assets...................................................................... 5-10

Revenue-to-Expense Ratio ...................................................................... 5-11

Market Quotations for Similar Risks ......................................................... 5-11

Pricing Guidelines................................................................................................ 5-12

Risk Identification ..................................................................................... 5-12

General Guidelines................................................................................... 5-13

Documentary Collections, Transfers, and Payment Orders .......... 5-13

Import Letters of Credit ................................................................. 5-14

Export Letters of Credit................................................................. 5-15

Trade Finance............................................................................... 5-16

Selling Trade Paper ...................................................................... 5-18

Presenting the Offer to the Customer .................................................................. 5-19

Unit Summary ...................................................................................................... 5-25

Progress Check 5 ................................................................................................ 5-27

Appendices

Appendix A — Glossary......................................................................................A-1

Appendix B – Index.............................................................................................B-1

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INTRODUCTION

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INTRODUCTION

OVERVIEW

“Trade” is the movement of goods and services that develops from a business transactionbetween a buyer and a seller. Facilitating trade is one of the most important activities ina bank. Because of the large number of legal, political, and business issues and risksinvolved in any trade transaction, Citibank has developed many different products toaccommodate its customers’ trade needs. This workbook is designed asan introduction to Citibank trade services and finance.

In the following pages we examine the global trade environment, discuss the tradeservices and products that are available to Bank customers, and analyze the risks andbenefits of these products and services to the Bank. We then identify several complianceissues that are essential to the safe and effective provision of trade services, and outlinethe process of pricing customer solutions.

COURSE OBJECTIVES

When you complete this workbook, you will be able to:

• Understand the global trade environment

• Recognize trade agreements, organizations, and other factors thatfacilitate / restrict global trade

• Recognize the documents required for trade transactions

• Identify Citibank trade products and services

• Understand the role of correspondent banks and export credit agenciesin providing trade products and services

• Identify the risks involved in trade transactions and understand howCitibank transfers risk

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• Recognize trade compliance issues and key regulations / legislation

• List and describe factors for analyzing customer needs and tradeopportunities

THE WORKBOOK

This workbook is designed to give you complete control over your own learning. Thematerial is divided into workable sections, each containing everything you need to masterthe content. You can move through the workbook at your own pace and go back to reviewideas that you didn’t completely understand the first time. Each unit contains:

Objectives – which point out important elements in thelesson that you are expected to learn.

Text – which is the “heart” of the workbook. Thissection explains the content in detail.

Key Terms – which also appear in the Glossary. Theyappear in bold face the first time theyappear in the text.

InstructionalMapping –

terms or phrases in the left margin whichhighlight significant points in the lesson.

þ Progress Checks – which do exactly what they say — checkyour progress. Appropriate questions arepresented at the end of each unit, or withinthe unit in some cases. You will not begraded on these by anyone else; they areto help you evaluate your progress. Eachset of questions is followed by an AnswerKey. If you have an incorrect answer, weencourage you to review the correspondingtext and find out why you made an error.

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In addition to these unit elements, the workbook includes:

Appendix A,Glossary –

Which contains definitions of all key termsused in the workbook.

Appendix B,Index –

Which helps you locate glossary items in theworkbook.

Each unit covers an aspect of trade services and trade finance. The units are:

UNIT 1 – The Trade Environment

UNIT 2 – Trade Services

UNIT 3 – Trade Finance

UNIT 4 – Risk and Compliance

UNIT 5 – Identifying Customers’ Needs and Pricing Solutions

Since this is a self-instructional course, your progress will not be supervised. We expectyou to complete the course to the best of your ability and at your own speed. Now thatyou know what to expect, please begin with Unit 1. Good luck!

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Unit 1

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UNIT 1: THE TRADE ENVIRONMENT

INTRODUCTION

At Citibank, we strive to be the most competent, profitable, and innovative financialservice organization in the world. To accomplish this goal, we must continually assessthe environment in which we operate, offer trade solutions that best meet our customers’needs, and measure the risks associated with conducting business.

We begin this unit by examining the global trade environment and the factors that enableor restrict the flow of goods and services. We then describe the European Communityand discuss three agreements that affect trade in the Latin American region as well as twomultinational agreements / organizations that promote trade. A description of the exportcredit agencies in several countries and the multilateral agencies that facilitateinternational commerce completes our study of the trade environment.

UNIT OBJECTIVES

When you complete Unit 1, you will be able to:

n Recognize issues and identify factors that restrict / promote global trade

n Recognize trade agreements in Latin America and Europe that promoteregional trade

n Recognize two multinational organizations that promote international trade

n Identify government support programs for national exports

n Distinguish between export credit agencies and multilateral agencies

n Recognize the role of the World Bank, its affiliates, and regionaldevelopment banks in promoting international trade

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OVERVIEW

In the past, trade was conducted directly between countries. Today,countries have grouped themselves into trading blocks to:

n Reinforce their individual strengths

n Strengthen their positions in the trade environment

Each block of countries has its own set of rules and regulations fordomestic, intrablock, and global trade.

To support the global interests of their customers, banks either havea multiblock presence or they have special arrangements with otherbanks operating in a region. These special arrangements, calledcorrespondent relationships, are discussed in Unit 3.

Factors restrictor promoteflow of goods

Political, business, social, and legal issues affect the global tradeenvironment. As trade officers, we need to carefully analyze allaspects of the environments in which our customers conduct theirbusiness.

Political Issues

Political issues (e.g. civil wars, riots, political unrest, andrevolutions) occur in all parts of the world and affect global trade.For example, many political changes are taking place in Chinatoday. We must monitor China’s adherence to the InternationalChamber of Commerce (ICC) rules in order to act as trade advisorsto our customers.

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Business Issues

Basic differences in the business philosophies of eastern andwestern countries also must be considered. In western countries,companies tend to focus on shareholders first and then oncustomers and employees. In eastern countries, these prioritiesare usually reversed – the customer and his/ her needs are mostimportant.

Social Issues

When conducting business in the world marketplace, we mustacknowledge cultural traditions, social welfare, social behaviors,and the influence of religion on consumption behavior.

Legal Issues

Legal issues that affect business include licensing arrangements,ownership questions, and local laws. Other legal concerns are tariffsand quotas.

As we mentioned earlier, political, business, social, and legal issuesaffect the global trade environment. Factors related to these issuesmay restrict or promote global trade. Let’s first examine thosefactors that limit global trade.

FACTORS THAT RESTRICT GLOBAL TRADE

Most countries appear to conform to international principlesof free trade. However, some countries impose trade-restrictingmeasures such as tariffs, nontariff barriers, and quotas on tradingpartners.


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Tariffs

Taxes onimported goods

Tariffs are taxes that are placed on imported goods to:

n Protect domestic businesses from foreign competition

n Discriminate, if they apply unequally to products ofdifferent countries

n Retaliate, if they are designed to compel another country toremove artificial trade barriers

Example The tariff imposed on Japanese motorcycles is an example of aprotective tariff. In 1983, Harley-Davidson, a US manufacturer, washaving difficulty competing with the heavyweight bikes importedfrom Japan by Honda and Kawasaki. The US Government imposeda five-year tariff on Japanese bikes imported into the United States.This gave Harley-Davidson management time to reorganize thecompany and become competitive again — without pressure fromthe Japanese imports. By 1987, Harley-Davidson had regained itsshare of the market in the heavyweight class of bikes and requestedthat the tariff be lifted a year early.

Nontariff Barriers

Import-restrictingmeasures

Nontariff barriers consist of a variety of measures that restrictimports. These measures include testing, certification, orbureaucratic hurdles.

Example An interesting example of bureaucratic hurdles occurred in Francein 1983. The French government decided to reduce the importationof foreign video recorders and mandated that all recorders had tobe sent to the customs station at Poitiers — which was far from thenormal transportation routes. Because the station was understaffed,operated only a few days per week, and each individual packagehad to be opened, the import of video recorders was effectivelystopped. Meanwhile, the French were able to assert their adherenceto international agreements.


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Quotas

Restrictionson quantityof importsand exports

Quotas are restrictions on the quantity of specific products that canbe imported and exported. Sometimes import quotas are imposedto prevent damage to a domestic industry, e.g. clothing and textiles.Occasionally, this action has unexpected results.

Example For example, in the early 1970s, quotas placed on tuna fish packedin oil from Japan prevented the tuna from entering the US market.This forced the Japanese to concentrate on packing tuna in watereven though, at that time, only 7% of tuna was packed in water.The Japanese became quite successful and created a niche forthemselves in the tuna-packed-in-water market.

Export quotas are set for reasons of national defense, economicstability, and price support. For example, it is United Statesgovernment policy to control the export of weapons and hightechnology that may have an adverse effect on national security.

Tariffs, nontariff barriers, and import and export quotas all functionto restrict or limit foreign trade. There also are several methods thatserve to promote global trade.

FACTORS THAT PROMOTE GLOBAL TRADE

The current trend in international trade is to open markets thattraditionally have been protected with restrictive factors suchas quotas and tariffs. In this section, we describe:

n Trade agreements that were created to encourageinternational trade (European Community, NAFTA,MERCOSUR, and Pacto Andino)

n Trade agreements / organizations (GATT and ALADI)that Latin American countries have joined to strengthentheir commitment to global trading


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n Government and multilateral agencies (MLAs), throughwhich governments provide financial assistance to supportworld trade (export credit agencies [ECAs], World Bank,and regional development banks)

Trade Agreements

A trade agreement is an agreement between two or more countriesconcerning the buying and selling of each country’s goods andservices. Countries enter into trade agreements to facilitate tradeamong the member countries. Their objectives are to:

n Diversify export markets

n Create or explore trade opportunities without barriers

n Protect products from other markets

n Encourage economic development of the region

While there are many trade agreements in different parts ofthe world, one plays a major role in Europe (the EuropeanCommunity [EC]), and three of them directly influence tradein Latin America: North American Free Trade Agreement(NAFTA), MERCOSUR, and Pacto Andino.

European Community

The European Community (EC) is a group of European countriesthat have joined together to establish a common market whichassures the free movement of people, goods, services, and capital.


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Member States As of 1995, the EC consisted of the following 15 member states(countries): Austria, Belgium, Denmark, Finland, Germany, Greece,France, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain,Sweden, and United Kingdom. Other countries are being consideredfor membership.

EuropeanCommunity vs.Free-trade Zone

The European Community has established a customs unionconsisting of a common customs tariff and a customs code. It alsohas at its disposal commercial policy instruments for ensuring thatits products and services have access to third-country markets. TheEC uses instruments to ensure equal competition between itself andthird countries on the basis of anti-dumping and anti-subsidy laws.

The EC is different from a free-trade zone. The EC has a commoncustoms tariff and a customs code. On the other hand, in a free-tradezone, each member country:

n Retains its own customs tariff and customs code

n Decides its national trading policy quite independently

A free-trade zone does not constitute a uniform trading bloc withthird countries.

The European Community is the largest trading power in the world –even larger than the United States or Japan. While all three havelarge domestic markets, they are not growing as rapidly as otherinternational markets and, as a result, the competition among thethree is intense for other international markets.


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North American Free Trade Agreement (NAFTA)

Canada, theUnited States,and Mexico

In 1994, the North American Free Trade Agreement becameeffective to facilitate the flow of goods and capital betweenCanada, the United States, and Mexico. These countries haveagreed to establish a free trade zone among their territories and toconsider products, services, and capital from any of the threecountries as if they were their own. NAFTA represents the largestworld market with 370 million consumers. Its main objectives areto:

n Eliminate trade barriers and facilitate the cross-border flow ofgoods and services among the parties

n Promote fair conditions for competition within the free tradezone

n Significantly increase investment opportunities

n Provide adequate protection to patent holders, copyrights,and transfers of technology — and to guarantee that allintellectual property can be traded safely

n Create effective procedures for the implementation of thistreaty, its joint administration, and resolution for disputes

n Establish parameters and guidelines for future regional andmultilateral (involving more than two countries or parties)cooperation to improve and expand the benefitsof NAFTA

The last objective is especially important because NAFTA is designedfor the eventual participation of other countries. Chile, for example,is interested in joining in the near future. In addition, Canada hasexpressed an interest in inviting non-Latin American countries suchas Australia and other Pacific Rim countries.


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MERCOSUR

Argentina,Brazil,Paraguay, andUruguay

The Southern Cone Common Market (MERCOSUR) is anagreement between Argentina, Brazil, Paraguay, and Uruguay tocreate a common market for the member countries. The agreement,which became fully operational on January 1, 1995, has thefollowing objectives:

n Establish the free movement of capital, goods, services,and people

n Create a common trade tariff structure and establish acommon policy

n Coordinate macroeconomic policies

MERCOSUR establishes an automatic progressive tariff scheduleto phase out existing tariffs in a period of three to four years and toremove restrictions on the movement of labor, goods, and services.The consumer and productivity potential for member countries issignificant. MERCOSUR is modeled after the European Community(EC) and, if successful, will encompass a geographical area that istwice the size of the EC.

Chile became an associate MERCOSUR member in early 1996. Peru,Ecuador, Venezuela, Colombia, and Bolivia have agreed to starttalks to link the Pacto Andino with MERCOSUR.


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Pacto Andino (Andean Pact)

Peru, Ecuador,Colombia,Chile, Bolivia,and Venezuela

The third agreement that influences Latin American trade is thePacto Andino (Andean Pact). Peru, Ecuador, Colombia, Chile,Bolivia, and Venezuela entered into this agreement to form aLatin American common market. These countries agreed to createcommon rules for foreign investment and an eventual commonexternal tariff.

Unfortunately, the Andean Pact has not had much success inachieving its goals. During the seventies and eighties, the LatinAmerican countries were affected by the external debt crisis andforced to concentrate on their individual problems rather than onregional matters.

Several Andean countries are trying to revive the arrangement toserve broader regional trading objectives. In 1993, Venezuela,Colombia, and Peru adopted a uniform tariff.

The objectives of the Andean Pact are to:

n Promote peaceful and equal development among its members

n Encourage an acceleration of growth through economicintegration

The emphasis on opening new markets brings renewed hope forgrowth in the global trade environment. We now look at twomultinational organizations which enhance global competition.

Trade Agreements / Organizations

Two multinational trade agreements / organizations that promoteinternational trade are General Agreement on Tariffs and Trade(GATT) and Asociación Latino-Americana de Integración(ALADI). They encourage orderly international financial conditionsand provide advice on capital and economic development.


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General Agreement on Tariffs and Trade (GATT)

Abolishesquotas andreduces tariffs

The General Agreement on Tariffs and Trade (GATT) is anorganization with a set of trade agreements created to abolish quotasand reduce tariffs among participating nations. It was originallycreated in 1947 as a temporary arrangement, pending its replacementby a UN agency. The UN agency was never established, and GATTwas expanded at several succeeding negotiations. It has proven to beone of the most effective instruments for world trade liberalization.

At its international headquarters in Geneva, GATT has a secretariat,a Council of Representatives, an annual assembly called the Sessions,and an International Trade Center. With over 100 member countries,GATT affects almost 90% of world trade.

The provisions of GATT include:

n A schedule of tariff concessions for each participatingnation

n Unconditional most-favored-nation clauses thatguarantee other GATT countries the extension ofany tariff concessions that have been granted tonon-GATT countries

n Elimination of quotas and other trade restrictions

n Uniform custom regulations and the obligation of eachcontracting nation to negotiate for tariff cuts upon therequest of another member nation


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Asociación Latino-Americana de Integración (ALADI)

The Asociación Latino-Americana de Integración (ALADI) is anorganization established by the Treaty of Montevideo in 1980. Itbegan as an agreement signed in 1965 under the Asociación Latino-Americana de Libre Comercio (ALALC). Member countries includeArgentina, Brazil, Mexico, Chile, Colombia, Peru, Uruguay,Venezuela, Bolivia, Ecuador, and Paraguay.

Promotesfinancialrelationshipsamong privatebankingagencies

ALADI’s purpose is to promote financial relationships amongprivate banking agencies. It provides its members with a mechanismfor financing for Latin American intraregional trade. ALADI allowsfor central bank payment guarantees of short and medium-termtrade credits among banks of member customers.

ALADI is a clearing system between the Central Banks of themember countries. Clearing occurs three times a year and settlesall import and export transactions under the ALADI agreementbetween member countries. The settlement between the CentralBanks is in US dollars only.

ALADI’s Council of Ministers is comprised of the foreign ministersof the member countries. The Conference of Contracting Partiesmakes decisions on questions requiring a resolution of the members.The Secretariat performs technical and administrative duties.

Export Credit and Multilateral Agencies

Direct andindirectgovernmentinvolvement

Commercial banks are not the only entities involved in financingworld trade and economic development. Governments participatein these activities, both directly through their own nationalorganizations (export credit agencies) and indirectly through theirmembership in a variety of international economic organizations(multilateral agencies).


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Export Credit Agencies (ECAs)

Support andexpand localexports

Export Credit Agencies are national organizations that support andexpand local exports to benefit the country’s balance of paymentsand, as a result, create jobs in the local market. The ECA programsenable the Bank’s customers (exporters) to remain competitive withbusinesses from other countries. Importers also benefit from accessto preferential rates and terms for loans from programs of theexporting countries.

ECA programs ECA assistance is provided in the form of guarantees or insuranceas well as direct lending. ECA programs include:

n Insurance to national exporters and commercial banksagainst commercial (credit) and/or country risks

n Payment guarantees to commercial banks involved inexport financing

n Preferential fixed interest rate loans to foreign importers

In Unit 3 we provide additional details on the differentcharacteristics of the ECAs.

Multilateral Agencies

Governments working together have established institutions whosepurpose is to maintain orderly international financial conditions andto provide capital and advice for economic development, particularlyin those countries that lack the resources to do it themselves. Theseinstitutions or multilateral agencies play an increasing role in thefinancing of large export contracts and projects. We discuss first theglobally-oriented World Bank, its entities and affiliates, and thenexamine the role of regional development banks.


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World Bank Group

The World Bank Group is comprised of the InternationalBank for Reconstruction and Development (IBRD) andthe International Development Association (IDA) and twoaffiliates, the International Finance Corporation (IFC) andthe Multilateral Investment Guarantee Agency (MIGA).Let’s examine their specific roles.

World Bank The World Bank is a multilateral development agency. Itspurpose is to help member countries progress economicallyand socially so that their people may live better and fuller lives.

The World Bank is the primary source of funding for projectsin emerging-market countries when private capital cannot beraised. In addition to lending medium and long-term fundsdirectly to governments in the emerging markets, the WorldBank provides technical and financial aid to private-sectorcompanies for direct investments.

World Bankentities: IBRDand IDA

The term “World Bank” refers to two legally and financiallydistinct entities: the International Bank for Reconstructionand Development (IBRD) and the International DevelopmentAssociation (IDA). The IBRD and IDA have three relatedfunctions:

• Lend funds

• Provide economic advice and technical assistance

• Serve as a catalyst to investment by others

Both the IBRD and the IDA provide training and technicaladvice to help developing countries address their ownproblems. However, the IBRD makes market-rate loansto newly industrialized countries (e.g. Korea, Brazil) byborrowing in the world capital markets. The IDA extendsassistance to the poorest countries on easier terms (e.g.,interest-free loans), largely from resources provided by itswealthier members.


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Funds from such other sources as governments, commercialbanks, export credit agencies, and other multilateral institutionsare increasingly being paired with World Bank funds tocofinance projects.

World Bank Affiliates

IFC and MIGA The International Finance Corporation (IFC), an affiliate ofthe World Bank, is the world’s largest multilateral organizationspecifically structured to provide loans to — and equityinvestments in — private companies in the emerging markets.It seeks to promote growth in the private sector of the emergingmarket countries by mobilizing foreign and domestic capital toinvest alongside its own funds in commercial enterprises.

The Multilateral Investment Guarantee Agency (MIGA), alsoan affiliate, encourages foreign direct investment in emergingmarkets countries by providing:

• Investment guarantees against the risks of currencytransfer, expropriation, war and civil disturbance,and breach of contract by the host government

• Advisory services to MIGA’s member countries onmeans of attracting foreign investment

Overseas Private Investment Corporation (OPIC)

The Overseas Private Investment Corporation (OPIC) isa profit-making US government agency. Its primary objectiveis to insure or guarantee US investment in more than 130developing countries throughout the world. It also offerssome export finance assistance. OPIC’s programs provide:

• Project financing through direct loans and loanguarantees


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• Investment insurance, including coverage for mediumand long term loans from Citibank NY to its branchesand subsidiaries, against a broad range of country risks

• A variety of investor services (e.g. advisory services,country and regional information)

OPIC’s insurance program protects investors and commercialbank lenders against the risk of inconvertibility of a currency,loss of investment due to expropriation, nationalization, orconfiscation by action of a foreign government or loss dueto political upheavals such as revolution or civil war. OPIC’sinsurance program does not protect commercial bank lendersor investors from the commercial risk, i.e. credit and foreignexchange risk.

Regional Development Banks

Regional development banks provide funding for buildinginfrastructures and private businesses in emerging marketscountries. Even if a project does not meet the necessary criteriafor financing from the development bank, assistance is stillavailable to help companies locate direct investment financingfrom other sources.

The most important regional development banks are ownedby the governments of many donor countries, both from theindustrialized world and from emerging markets, and servemainly as central banks for local development banks. They alsooffer direct financing to private sector-businesses. The mostimportant development banks are:

• The Inter-American Development Bank (forLatin America)

• The Asian Development Bank (for Asia andthe Pacific)


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• The African Development Bank and Fund(for Africa)

• The European Bank for Reconstruction andDevelopment (for Eastern Europe and theCommonwealth of Independent States)

• The European Investment Bank (for the fundingof worldwide interests of the European Union)

• Corporacion Andina de Fomento (for PactoAndino countries)

UNIT SUMMARY

In this unit, we examined some political, business, social,and legal conditions that promote or restrict global trade.We considered the factors that limit global trade — tariffs,nontariff barriers, and quotas. We introduced the tradeagreement that plays a major role in Europe and the threeagreements that encourage trade in the Latin American region,as well as two multinational organizations created to helpcountries compete in the world marketplace.

We described governments’ direct and indirect contributionsto the promotion of international trade. Export credit agenciesin the US and other countries are established by nationalgovernments to support exports and improve the country’sbalance of payments. Multilateral agencies, such as the WorldBank and regional development banks, seek to maintainorderly international financial conditions and provide capitaland advice for economic development.

You have completed Unit 1, The Trade Environment. Please complete the Progress Checkto test your understanding of the concepts and check your answers with the Answer Key.If you answer any questions incorrectly, please reread the corresponding text to clarifyyour understanding. Then, continue to Unit 2, Trade Services.


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þ PROGRESS CHECK 1

Directions: Determine the one correct answer to each question unless directedotherwise. Check your answers with the Answer Key on the next page.

Question 1: Determine how the following factors affect the trade environment. Placea P for those that promote trade and an R for those that restrict trade.

_____ Civil unrest in the country where the goods are being exported

_____ A country importing goods is a member of GATT

_____ A quota has been placed on imports of leather shoes

_____ An export credit agency will provide preferential financing rates toforeigners who buy that country’s exports

_____ A multilateral agency guarantees repayment of a Citibank loan to acustomer from an emerging-market country who is purchasingcomputers from a US firm

_____ A new trade agreement establishes a free trade zone in participating countries

_____ To protect its own bicycle market, a country places a tariff on imported bicycles

_____ An importer in an emerging-market country receives low-cost financingfrom a World Bank entity.


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ANSWER KEY

Question 1: Determine how the following factors affect the trade environment. Placea P for those that promote trade and an R for those that restrict trade.

R Civil unrest in the country where the goods are being exported

P A country importing goods is a member of GATT

R A quota has been placed on imports of leather shoes

P An export credit agency will provide preferential financing rates to foreigners who buy that country’s exports

P A multilateral agency guarantees repayment of a Citibank loan to a customer from an emerging-market country who is purchasing computers from a US firm

P A new trade agreement establishes a free trade zone in participating countries

R To protect its own bicycle market, a country places a tariff on imported bicycles

P An importer in an emerging-market country receives low-cost financing from a World Bank entity


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þ PROGRESS CHECK 1(Continued)

Question 2: Which agreement establishes a free trade zone in Canada, the United States,and Mexico?

_____ a) Pacto Andino_____ b) ALADI

_____ c) MERCOSUR

_____ d) NAFTA

Question 3: A small country in Latin America requires the inspection of importedtoasters. The inspector’s office is open one day a week and is understaffed.This is an example of a(n):

_____a) nontariff barrier.

_____b) import quota.

_____c) tariff.

_____d) export quota.

Question 4: One of the reasons tariffs are placed on imported goods is to:

_____ a) promote competition between domestic and foreign goods.

_____ b) encourage foreign trade.

_____ c) control imports.

_____ d) create a favorable trade climate.

Question 5: The trade agreement which creates a common market for Argentina, Brazil,Paraguay, and Uruguay is:

_____a) MERCOSUR.

_____b) Pacto Andino.

_____c) ALADI.

_____d) HERMES.


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ANSWER KEY

Question 2: Which agreement establishes a free trade zone in Canada, the United States,and Mexico?

d) NAFTA

Question 3: A small country in Latin America requires the inspection of importedtoasters. The inspector’s office is open one day a week and is understaffed.This is an example of a(n):

a) nontariff barrier.

Question 4: One of the reasons tariffs are placed on imported goods is to:

c) control imports.

Question 5: The trade agreement which creates a common market for Argentina, Brazil,Paraguay, and Uruguay is:

a) Mercosur.


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Question 6: Which multinational agreement / organization has over 100 membercountries that account for almost 90% of world trade?

_____ a) ALADI

_____ b) NAFTA

_____ c) Pacto Andino

_____ d) GATT

Question 7: Which multinational agreement / organization provides a mechanism forfinancing to its members for Latin American intraregional trade?

_____ a) ALADI

_____ b) NAFTA

_____ c) Pacto Andino

_____ d) GATT

Question 8: Which trade agreement has created the largest trading power in the world?

_____ a) NAFTA

_____ b) GATT

_____ c) ALADI

_____ d) MERCOSUR

_____ e) Pacto Andino

_____ f) European Community


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ANSWER KEY

Question 6: Which multinational agreement / organization has over 100 membercountries that account for almost 90% of world trade?

d) GATT

Question 7: Which multinational agreement / organization provides a mechanism forfinancing to its members for Latin American intraregional trade?

a) ALADI

Question 8: Which trade agreement has created the largest trading power in the world?

f) European Community


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Question 9: Export credit agencies (ECAs) are established by:

_____ a) commercial banks.

_____ b) free trade agreements.

_____ c) governments.

_____ d) multilateral agencies.

Question 10: Identify two banks that are World Bank entities.

_____ a) International Bank for Reconstruction and Development

_____ b) African Development Bank and Fund

_____ c) Inter-American Development Bank

_____ d) International Development Association

Question 11: The trade agreement that has had the least amount of success inachieving its goals, primarily due to an external debt crisis in theseventies and eighties is:

_____ a) ALADI.

_____ b) Pacto Andino.

_____ c) GATT.

_____ d) MERCOSUR.


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ANSWER KEY

Question 9: Export credit agencies (ECAs) are established by:

c) governments.

Question 10: Identify two banks that are World Bank entities.

a) International Bank for Reconstruction and Development

d) International Development Association

Question 11: The trade agreement that has had the least amount of success inachieving its goals, primarily due to an external debt crisis in theseventies and eighties is:

b) Pacto Andino.


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Question 12: A small Guatemalan company is seeking financing to build a plant andpurchase US equipment in order to export textile to the US. The twoagencies most likely to assist with financing are:

_____ a) ECA.

_____ b) OPIC.

_____ c) MIGA.

_____ d) IFC.

Question 13: Select the statement that best describes the difference between an exportcredit agency (ECA) and a multilateral agency.

_____ a) An ECA is an international organization that provides informationto local exporters and their importers. Multilateral agencies provide funding to promote trade between emerging market countries.

_____ b) ECAs within countries support the expansion of local exports. Multilateral agencies provide informational and financial assistanceto support export activities in countries that lack the resources to doit themselves.

_____ c) An ECA is a local agency affiliated with the Bank to assist customersin broadening their foreign markets. Multilateral agencies are international insurance agencies that provide capital to emergingmarket countries that compete for large export contracts.

_____ d) Multilateral agencies provide funding to local companies that are just beginning to expand into foreign markets. ECAs provide low-cost, variable rate financing to foreign importers.


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ANSWER KEY

Question 12: A small Guatemalan company is seeking financing to build a plant andpurchase US equipment in order to export textile to the US. The twoagencies most likely to assist with financing are:

a) ECA. (to finance the purchase of US equipment)

d) IFC. (to finance the construction of the plant)

Question 13: Select the statement that best describes the difference between an exportcredit agency (ECA) and a multilateral agency.

b) ECAs within countries support the expansion of local exports.Multilateral agencies provide informational and financial assistanceto support export activities in countries that lackthe resources to do it themselves.


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Question 14: In emerging market countries, when private capital cannot be raised forlarge infrastructure improvement projects, governments may obtain market-rate funding from the:

_____ a) local export credit agency.

_____ b) World Bank Group’s International Development Association.

_____ c) World Bank Group’s International Bank for Reconstructionand Development.

_____ d) Overseas Private Investment Corporation.

Question 15: Match each of the following organizations with its role in promotinginternational trade.

_____ International Finance Corporation (IFC)

_____ Multilateral Investment Guarantee Agency (MIGA)

_____ Overseas Private Investment Corporation (OPIC)

_____ Regional development banks

1. Affiliate of the World Bank that provides investment guaranteesagainst country risks and advice to member countries on how to attractforeign investment

2. Provides funding or assistance in locating funding for buildinginfrastructures and private businesses in emerging market countries

3. Affiliate of the World Bank that promotes private sector growth inemerging market countries through direct investing and attractingforeign and domestic investors

4. US government agency with the primary objective of protectingUS investments in developing countries against country risk


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ANSWER KEY

Question 14: In emerging market countries, when private capital cannot be raised forlarge infrastructure improvement projects, governments may obtain market-rate funding from the:

c) World Bank Group’s International Bank for Reconstructionand Development.

Question 15: Match each of the following organizations with its role in promotinginternational trade.

3 International Finance Corporation (IFC)

1 Multilateral Investment Guarantee Agency (MIGA)

4 Overseas Private Investment Corporation (OPIC)

2 Regional development banks

1. Affiliate of the World Bank that provides investment guaranteesagainst country risks and advice to member countries on how to attractforeign investment

2. Provides funding or assistance in locating funding for buildinginfrastructures and private businesses in emerging market countries

3. Affiliate of the World Bank that promotes private sector growth inemerging market countries through direct investing and attractingforeign and domestic investors

4. US government agency with the primary objective of protectingUS investments in developing countries against country risk


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Question 16: Quotas are an example of ___________ issues which affect the global tradeenvironment.

_____ a) political

_____ b) business

_____ c) social

_____ d) legal


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ANSWER KEY

Question 16: Quotas are an example of ___________ issues which affect the global tradeenvironment.

d) legal

Unit 2

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UNIT 2: TRADE SERVICES

INTRODUCTION

In an international trade transaction involving goods or services, the buyer and theseller negotiate details about the method and timing of both payments and delivery.These negotiations require attention to complex details concerning credit arrangements,transaction structuring, legal issues, and political and cross-border risks. Citibankcustomers, whether buyers and/or sellers, involved in an international trade transactionrely on the expertise of a global bank like Citibank for advice and assistance regardingthese complex details.

In the first two parts of this unit, you will learn about international payment options andhow Citibank and Citibank customers use trade services to reduce the risks associatedwith trade transactions. In the third part, you will learn about the financial andcommercial documents that facilitate international trade.

UNIT OBJECTIVES


n Identify the effect of leverage in a trade transaction

n Identify five payment options for settling trade transactions

n Recognize the risks and advantages of the five payment optionsto buyers and sellers, as well as the role and risks for Citibank

n Distinguish between the two major categories of letters of credit – commercialletters of credit and standby letters of credit

n Understand the application of different types of letters of creditto international trade transactions

n Recognize the commercial and financial documents needed fora typical international trade transaction

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ESTABLISHING TERMS BETWEEN BUYERS AND SELLERS

Whenever goods are bought and sold, the buyer (importer) and theseller (exporter) conduct negotiations to determine the terms of thetransaction. The terms of the transaction establish how much, when,and in what form the buyer will pay the seller.

Buyer’s goals The buyer’s goals during the negotiations are to:

n Minimize the total cost of the goods which, in addition tothe agreed-upon price, may include:

• Cost of financing the goods between the time theyare purchased and the time they are converted intocash upon subsequent resale

• Lost opportunity cost of not being able to investfunds in the event available cash is used to pay forthe goods

• Foreign exchange costs if the deal is denominatedin a currency other than the buyer’s

n Maintain good relationships with sellers

Poor payment practices may offend suppliers of materials thatare critical to the production of the buyer’s goods. Conversely,the relationship with a seller who offers lenient payment termsis a valuable resource that the buyer will want to protect.

n Assure receipt of specified goods previously contracted withthe seller

Seller’s goals The seller’s goals are to establish terms that:

n Increase the attractiveness of the product. By offering lenienttrade terms to the buyer, it increases the likelihood that thebuyer can afford the product.

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n Maximize the price of the goods without losing the sale

Either through borrowing or through available cash, the sellermust cover the cost between the time the sale is contractedand the final payment is received. The seller may try to buildthis cost into the price of the product, but runs the risk ofmaking the goods less attractive.

n Assure payment from the buyer. The seller will examine allthe risks associated with the trade transaction to ensure that—

• The buyer is able to pay

• Funds can be converted to the currency of theseller’s country

• Funds can be transferred to the seller’s country Leverage The party with the most business influence during the negotiations

will be more successful in dictating terms that meet the desiredobjectives. In other words, the amount of leverage each partyhas determines how many goals the seller and buyer will achieve.For example, a buyer who regularly purchases 90% of a seller’sproduct may be able to negotiate very favorable payment termswith that seller.

PAYMENT OPTIONS

After establishing the terms of the deal, the two parties draw up acontract and the buyer issues a purchase order. The buyer and sellerarrange one of five major payment options to settle the transaction:

n Cash in advance

n Open account

n On consignment

n Documentary collections

n Letters of credit

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In the next two sections, “Cash in Advance” and “Open Account,”we examine the distinct characteristics of these payment options anddiscuss their advantages and risks to the buyer and seller, as wellas the role and risks for Citibank.

Cash in Advance

Payment beforeshipment

Cash in advance is the most basic payment method for goods.The seller receives cash from the buyer before goods are shipped.

Buyer’sadvantagesand risks

There are no advantages to the buyer in this transaction and thereare several risks to consider. For instance:

n Lack of control over the goods

n Loss of the use of the funds paid to the seller

n Refusal or inability of the seller to ship the goods

n Political (sovereign) risk in the seller’s country until thegoods are shipped. Political (sovereign) risk, a componentof country risk, is the possibility that the actions of asovereign government (e.g. nationalization or expropriation)or independent events (e.g., wars, riots, civil disturbances)affect the ability of the seller in that country to meet itsobligations to the buyer. (We will examine political riskin greater detail in Units Three and Four.)

n Commercial or credit risk of the seller as a result of fundsmisuse, bankruptcy, or any other improper business activity

Seller’sadvantagesand risks

The seller has all of the advantages in the cash-in-advancetransaction and almost none of the risks. The seller can ship thegoods whenever convenient and, in the meantime, enjoy the use ofthe buyer’s funds.

Citibank’s role Citibank has minimal involvement in a cash-in-advance transaction.However, it can derive fee income from transactions associated withfunds transfer, foreign exchange (if required), and cash management.

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The advantages and risks of a cash-in-advance transaction and therole of Citibank are illustrated in Figure 2.1.

CASH IN ADVANCEThe seller receives cash from the buyer prior to shipment.

Advantages Risks

BUYER n None n Buyer has no control over goodsn Buyer loses use of funds paid to

the sellern Seller may refuse to, or be

unable to, ship the goodsn Political risk in the seller’s

countryn Seller’s commercial or credit risk

SELLER n Ships goods whenconvenient

n Enjoys use ofbuyer’s funds

n None

CITIBANK

n Has minimal involvement in this payment option. However,it can derive fee income from transactions associated withfunds transfer, foreign exchange (if required), and cashmanagement.

Figure 2.1: Cash in advance: Advantages and risks for buyer and seller and therole of Citibank

Situations Cash in advance transactions are arranged only in situations wherethe seller may have significant leverage and is able to dictate theterms of the deal — for example, when several buyers are competingfor a limited product.

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Open Account

Shipmentbefore payment

A second method of paying for merchandise in an internationaltrade transaction is the open account. The seller ships the goods,accompanied by the title documents (legal documents, e.g.insurance and transport documents, indicating proof of anindividual’s ownership of the goods), before receiving paymentor a written promise to pay (i.e. promissory note or draft). Theshipper does not retain control of the goods.

The flow of goods and cash in an open account payment option isillustrated in Figure 2.2.

(1) Shipmentof goods

Titledocuments

(2) Payment

On theagreed

upon date,amount,currency

The buyer mayalso be theend-user of

the importedgoods

Figure 2.2: Open account flow

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The buyer has all of the advantages and minimal risk in an openaccount transaction. The buyer:

n Retains control of the goods

n Has time to generate cash from the sale of the goods beforepaying the seller to cover the period between the purchaseand resale of the goods. Nevertheless, lack of timelypayments may cause the facility to be discontinued.

Note: The length of time between the shipment of goods bythe seller and the payment by the buyer depends on the creditterms previously negotiated. The purchase order issued bythe buyer or the contract of sale represents the terms andconditions of the negotiation.

n May not have to borrow and can use available cash onreceipt of the merchandise

n May incur foreign exchange risk if the imported goodsare priced in the seller’s currency. The buyer may be unableto pay if its currency weakens sharply against the seller’scurrency.


The seller has none of the advantages and all of the risks in anopen account transaction. The seller:

n Has no control over the goods and the buyer’s willingnessto pay for them

n Incurs cross-border risk which may prevent an otherwisereputable buyer from sending payment. (Cross-border risk,a component of country risk, is the risk that, due to economicproblems, political disturbances, or sovereign actions withinthe buyer’s country, it may become impossible to get moneyout of a country or to convert the buyer’s currency into aforeign currency — See Unit 4 for more details on risks).

n May incur foreign exchange risk if the exported goods arepriced in the buyer’s currency

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n May need to borrow to cover the period between shipmentof the goods and receipt of funds. If the seller borrows ata floating rate, the seller may incur interest rate risk (theinterest rate at which the seller borrows may rise to thepoint in which the transaction may become unprofitablefor the seller).

Citibank’s role Citibank has minimal involvement in an open account transaction.However, it can derive fee income from transactions associated withfunds transfer, foreign exchange (if required), and cash management.Documentation for the shipment of the merchandise is handledoutside banking channels.

The advantages and risks of an open account transaction and the roleof Citibank are shown in Figure 2.3.

OPEN ACCOUNTBuyer receives goods and pays later through

an arrangement negotiated in advance with the seller

Advantages Risks

BUYER n Retains control over goodsn Pays when convenientn May not have to borrow

and can use availablecash

n Foreign exchange risk

SELLER n None n No control over goods andbuyer’s willingness to pay

n Cross-border riskn Foreign exchange riskn Interest rate risk

CITIBANK n Has minimal involvement in this payment option.However, it can derive fee income from transactionsassociated with funds transfer, foreign exchange (ifrequired), and cash management.

Figure 2.3: Open account: Advantages and risks for the buyer and sellerand the role of Citibank

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Situations The typical situations in which a seller would be willing to assumethe above risks are when the contract is:

n Between parent companies and subsidiaries to facilitateintra-company trade

n Between buyers and sellers with excellent long-termrelationships

n Between sellers and buyers, when sellers feel strongcompetitive pressures, especially in domestic markets

Cash in advance and open account are relatively simple procedures,but the risks involved are unevenly distributed between the buyerand seller. These two payment options are not suitable in transactionswhere the buyer and seller do not know each other very well, or theseller does not want to assume the credit risk and country risk whenoffering payment terms to the buyer.

The other three payment options — on consignment, documentarycollections, and letters of credit — may be more appropriate. Theseoptions reduce the risk to the seller and buyer and simplify the cashmanagement aspects of the transaction. We examine these optionsin detail in the sections that follow.

On Consignment

Seller shipsgoods butretainsownership

In an “on consignment” sale, the seller ships the goods to theimporter while retaining ownership of the goods. The importer isreferred to as the consignee who is actually an agent responsiblefor paying for the goods if and when the goods are sold.

Consignee’sadvantagesand risks

The prime advantage for the consignee is that the consignee paysonly as the imported goods are sold. The consignee receives afee for brokering the sale. There are no risks for the consignee.

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The key advantages for the seller are that the seller retainsownership of the goods until sold and uses the services of theconsignee to intermediate the sale of the goods to the buyer. Interms of risks, the seller:

n Has limited control over the goods

n Has no control over the consignee’s willingness to payfor goods

n Receives payment only upon sale of goods

n May incur cross-border risk of the consignee’s country

n May incur foreign exchange risk

n May incur commercial or credit risk

Citibank’s role Citibank has minimal involvement in an “on consignment”transaction. However, it can derive fee income from transactionsassociated with funds transfer, foreign exchange (if required), andcash management.

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The advantages and risks of an “on consignment” transaction and therole of Citibank are shown in Figure 2.4.

ON CONSIGNMENTThe seller ships goods to the consignee, but retains ownership.

Payment is made if and when the consignee sells the goods

Advantages Risks

CONSIGNEE n Pays only as goods aresold

n None

SELLER n Retains ownership of thegoods

n Consignee intermediatessale of goods to buyer

n Has limited control overgoods

n Has no control overconsignee’s willingness topay for goods

n Receives payment onlyupon sale of goods

n May incur:• Cross-border risk• Foreign exchange risk• Commercial or credit risk

CITIBANK n Has minimal involvement in this payment option. However,it can derive fee income from transactions associated withfunds transfer, foreign exchange (if required), and cashmanagement.

Figure 2.4: On consignment: Advantages and risks for the seller and consigneeand the role of Citibank

Situations Seller should only grant consignment terms to a:

n Reputable consignee with good credit ratings

n Consignee with whom the seller has a good credit history

n Consignee whose country enjoys economic and politicalstability

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Documentary Collections

Banks act uponinstructionsreceived

The fourth payment option, documentary collections, is a methodby which a seller is able to collect payment from an overseas buyerthrough an intermediary bank. Banks act as intermediaries infacilitating the flow of the title documents and in the payment ofthe transaction.

Parties andprocess

There are four major parties involved: the seller, remitting bank(seller’s bank), buyer, and collecting / presenting bank (buyer’sbank). There are four major steps in a documentary collection:

1. The seller, after effecting shipment, forwards to the remittingbank (seller’s bank) the following documents covering theshipment —

l Written collection instructions

l Draft (financial document which is a demand forpayment), and/or

l Commercial documents (e.g. commercial invoice,transport document, and any other documentapplicable to the collection transaction)

2. The remitting bank (seller’s bank), acting as an intermediary,transcribes the sellers’ collection instructions and forwards itto the collecting / presenting bank (buyer’s bank) along withthe draft and/or commercial documents.

3. The collecting / presenting bank, acting as an intermediary,makes the draft and/or commercial documents available to thebuyer for inspection and only delivers the original commercialdocuments in accordance with the remitting bank’s collectioninstruction.

4. The buyer, after inspecting the commercial documents, hasthree options: (i) to pay, (ii) to obligate itself to pay at a futuredate, or (iii) to refuse either to pay or to obligate itself to paythe accompanying draft.

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Seller requiresimmediatepayment

If the seller requires immediate payment of a collection and is notwilling to extend financing to a buyer, the seller will use a sightdraft. A sight draft is an order signed by the seller directing thebuyer to pay a specified amount to the seller upon presentation ofthe draft. The document and cash flow for documents againstpayment is illustrated in Figure 2.5.

n After shipping the goods (1), the seller sends a sight draftwith the commercial documents (transport documents,commercial invoice and any other document applicable tothe collection transaction) to the collecting / presenting bankthrough the remitting bank (2,3).

n The collecting / presenting bank releases the commercialdocuments to the buyer only upon payment of the sightdraft (4). The buyer must effect payment of this draft toreceive the commercial documents. The release of thedocuments to the buyer upon payment of a sight draft isknown as documents against payment (D/P collection).

n The collecting / presenting bank forwards the payment tothe seller through the remitting bank (5,6).

Sight draft anddocuments

( 1 )

( 4 )

( 5 )

Citibankremitting bank

Citibankcollecting / presenting bank

Sightdraft and

documentsin trust

( 3 )

Sight draft anddocuments

( 2 )

( 4 )

$( 6 )

Figure 2.5: Documentary collection flow for documentsagainst payment (D/P collection)

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Seller extendsfinancing

If the seller extends financing to the buyer, the seller uses a timedraft. A time draft is an order signed by the seller directing thebuyer to pay a specified amount to the seller on a specified futuredate. The document flow for documents against acceptance(D/A collection) is illustrated in Figure 2.6.

n After shipping the goods (1), the seller sends a time draftwith the commercial documents (transport documents,commercial invoice, and any other document applicableto the collection transaction) to the collecting / presentingbank through the remitting bank (2,3).

n The collecting / presenting bank releases the commercialdocuments to the buyer only upon the buyer obligating itselfto pay the accompanying draft. The buyer obligates itself topay by placing the word accepted across the face of a draftfollowed by the maturity date and the buyer’s signature. Therelease of the commercial documents to the buyer upon itsacceptance of the time draft is known as documents againstacceptance (D/A collection) (4,5,6). These steps occursimultaneously.

n The seller receives the accepted draft from the remittingbank and holds it to maturity (7); it may then be presentedfor payment under a D/P collection (Figure 2.5).

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Figure 2.6: Documentary collection flow for documents againstacceptance (D/A collection)

* Please note that these steps occur simultaneously.

Advantages and Risks to the Buyer, Seller, andCitibank


In a documentary collection transaction, the buyer’s advantage isthat the buyer may refuse to:

n Pay for drafts and/or documents

n Accept a time draft

In terms of risks, the goods may not meet the buyer’s specificationsafter payment and/or acceptance.


For the seller, the advantage is that the seller knows that thecommercial and/or financial documents are controlled by the banks,acting as intermediaries, and are not delivered to the buyer untilpayment is made or a time draft is accepted by the buyer.

Citibank collecting/ presenting

bank

(3) Time draftanddocuments

in trust

(6) Accepteddraft returned

to seller

( 1 )Goods

Citibankremittingbank

*(5) Accepted timedraft

*(5) Documentsreleased upon

acceptance

(2) Time draft anddocuments

(7) Accepteddraftreturned toseller

Time draft foracceptance

( 4 )

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A bank’s control of the documents reduces the seller’s risk inrelation to the documents only; however, the seller may beexposed to:

n Cross-border risk

n Foreign exchange risk

n Interest rate risk

n Commercial or credit risk

n Costs resulting from the buyer’s refusal to pay. In thisinstance, the seller incurs the expense of storing goods in aforeign country while finding another buyer in that country(or in another country), or arranging for their return to thecountry of origin.

n Loss of goods resulting from a time limit for holding goods inpublic storage. Regulations in many countries may restrict thenumber of days in which goods may be held in public storage.After that time, the goods may be sold at auction.

Citibank’sadvantagesand risks

In a documentary collection transaction, Citibank facilitates theflow of the title documents and of the payment of the transaction.Citibank does not deal with goods and does not assume any creditrisk — it acts only as an intermediary in the collection process.However, there are operational risks to consider:

n Citibank must follow the collection instructions issuedby the seller; otherwise it may incur a financial loss.

n Citibank must comply with US government regulations, inthe US and abroad, or it may be exposed to fines, civil andcriminal penalties, and negative publicity (See Unit 4).

n Citibank must comply with foreign government regulationsin their respective countries or it may be exposed to fines,civil and criminal penalties, and negative publicity.

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n Citibank must safeguard negotiable instruments since theycan be fraudulently endorsed and are freely negotiable inthe open market. For instance, time drafts, after acceptanceby buyers, become negotiable instruments and, as such,require safekeeping to protect Citibank from financial lossesand customer dissatisfaction.

In exchange for the risks, Citibank has an opportunity to increasefee-based revenues and to take advantage of cross-sell opportunitiesin cash management.

The advantages and risks of documentary collections for the buyer,seller, and Citibank are shown in Figure 2.7.

DOCUMENTARY COLLECTIONSThe seller ships goods to the buyer. The seller’s draft and title

documents are presented through the intermediary banks for payment.

Advantages Risks

BUYER n May refuse to payfor drafts and/ordocuments

n May refuse toaccept a time draft

n Goods may not meet buyer’sspecifications

SELLER n Commercial and/orfinancialdocumentscontrolled by banks

n Country, foreign exchange, interest rate,and commercial risks

n Buyer does not pick up documents orrefuses to pay

n Time limit for holding goods in publicstorage in the event of non-acceptance ofdocuments

CITIBANK n Fee-basedrevenues

n Cross-sellopportunities

n Not following collection instructionsn Not complying with US government

regulations, in the US and abroadn Not complying with foreign government

regulations in their respective countriesn Not safeguarding negotiable instruments

Figure 2.7: Documentary collections: Advantages and risks for buyer and sellerand risks for Citibank

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References The Uniform Rules for Collections (UCC), a publication of theInternational Chamber of Commerce (ICC), provides guidelines forparties / participants involved in collections transactions.

Summary

In international trade, buyers and sellers have different objectives:

n The buyer wants to ensure the receipt and quality of thegoods while structuring a favorable payment schedule. Assuch, buyers prefer the “open account” payment option.

n The seller wants to deliver the goods and receive payment asquickly as possible. As such, sellers prefer cash in advance.

Citibank has minimal involvement in those trade transactionsassociated with the first three payment options we discussed: “cashin advance,” “open account,” and “on consignment.” As a result, theBank does not incur any direct risk. On the other hand, Citibank canderive fee income from related transactions such as funds transfer,foreign exchange (if required), and cash management.

In terms of the fourth payment option, “documentary collections,”Citibank derives fee income from this payment option since it actsas an intermediary bank in facilitating the flow of the title documentsand in the payment of the transaction. Citibank incurs operationalrisks since it must deal with documents and negotiable instruments.

To check your understanding of the first four trade payment options,please complete Progress Check 2.1 and check your answers with theAnswer Key. If you answer any questions incorrectly, please rereadthe corresponding text to clarify your understanding. Then, proceedto the next section of Unit 2 where we discuss the fifth and finalpayment option, “Letters of Credit.”

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þ PROGRESS CHECK 2.1


Question 1: In negotiating a trade transaction, the party with the most leverage will:

_____ a) finance the seller.

_____ b) be able to dictate the terms.

_____ c) have none of the advantages.

_____ d) incur foreign exchange risk.

Question 2: In a documentary collection, the banks:

_____ a) monitor the quality of the goods shipped.

_____ b) assume the buyer’s credit risk.

_____ c) act as intermediaries in the collection process.

_____ d) verify that the number of goods shipped agrees with the title document.

Question 3: An exporter receives a purchase order and payment for 1500 pairs of shoes.This is an example of which type of payment option?

_____ a) Documentary Collections

_____ b) Open Account

_____ c) Cash in Advance

_____ d) On Consignment

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ANSWER KEY

Question 1: In negotiating a trade transaction, the party with the most leverage will:

b) be able to dictate the terms.

Question 2: In a documentary collection, the banks:

c) act as intermediaries in the collection process.

Question 3: An exporter receives a purchase order and payment for 1500 pairs of shoes.This is an example of which type of payment option?

c) Cash in Advance

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þ PROGRESS CHECK 2.1(Continued)

Question 4: The bank holds shipping documents in its custody and will only deliverthem to the buyer upon receipt of payment for the documents. If payment isnot received, the intermediary banks will look for further instructions fromthe seller. This is an example of:

_____ a) documents against acceptance.

_____ b) cash in advance.

_____ c) on consignment.

_____ d) documents against payment.

Question 5: An exporter receives a purchase order for two million radios and ships thegoods and title documents directly to the buyer before receiving paymentfor the goods. Which payment option is this?

_____ a) Open Account

_____ b) Documentary Collections

_____ c) On Consignment

_____ d) Cash in Advance

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ANSWER KEY

Question 4: The bank holds shipping documents in its custody and will only deliverthem to the buyer upon receipt of payment for the documents. If payment isnot received, the intermediary banks will look for further instructions fromthe seller. This is an example of:

d) documents against payment.

Question 5: An exporter receives a purchase order for two million radios and ships thegoods and title documents directly to the buyer before receiving paymentfor the goods. Which payment option is this?

a) Open Account

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þ PROGRESS CHECK 2.1 (Continued)

Question 6: A “cash in advance” transaction gives all of the advantages to the:

_____ a) buyer.

_____ b) seller.

Question 7: Identify the payment option(s) which expose the seller to the risk ofnonpayment by the buyer. (Select all that apply.)

_____ a) Cash in Advance


_____ c) Documentary Collections


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ANSWER KEY

Question 6: A “cash in advance” transaction gives all of the advantages to the:

b) seller.

Question 7: Identify the payment option(s) which expose the seller to the risk ofnonpayment by the buyer. (Select all that apply.)

b) Open Account

c) Documentary Collections

d) On Consignment

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Question 8: What payment option(s) should the seller consider when his/her productsare in high demand? (Select all that apply.)


_____ b) Documents Against Acceptance


_____ d) Documents Against Payment

Question 9: Identify the risk(s) faced by the seller when collecting payment from anoverseas buyer. (Select all that apply.)

_____ a) Country

_____ b) Foreign Exchange

_____ c) Commercial

_____ d) Interest Rate

_____ e) Operational

Question 10: What payment option(s) should the seller consider when the seller iswilling to extend credit to the buyer? (Select all that apply.)



_____ c) Documents Against Acceptance


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ANSWER KEY

Question 8: What payment option(s) should the seller consider when his/her productsare in high demand? (Select all that apply.)

a) Cash in Advance

d) Documents Against Payment

Question 9: Identify the risk(s) faced by the seller when collecting payment from anoverseas buyer. (Select all that apply.)

a) Country

b) Foreign Exchange

c) Commercial

d) Interest Rate

Question 10: What payment option(s) should the seller consider when the seller iswilling to extend credit to the buyer? (Select all that apply.)

b) Open Account

c) Documents Against Acceptance

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Question 11: In what payment option does the seller use the services of an importeror responsible agent to intermediate the sale of the goods to the buyer?


_____ b) Documents Against Acceptance



Question 12: In what payment option(s) do banks derive fee income when facilitatingthe flow of title documents and of the payment of the trade transaction?


_____ b) Documentary Collection


_____ d) Open Account

Question 13: What is the most common type of risk incurred by banks in a documentarycollection?

_____ a) Foreign Exchange

_____ b) Country

_____ c) Operational

_____ d) Interest Rate

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ANSWER KEY

Question 11: In what payment option does the seller use the services of an importeror responsible agent to intermediate the sale of the goods to the buyer?

c) On Consignment

Question 12: In what payment option(s) do banks derive fee income when facilitatingthe flow of title documents and of the payment of the trade transaction?

b) Documentary Collection

Question 13: What is the most common type of risk incurred by banks in a documentarycollection?

c) Operational

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Question 14: Banks acting as intermediaries of a trade transaction can derive more feeincome from:

_____ a) documents against payment.

_____ b) documents against acceptance.

_____ c) the “on consignment” option.

_____ d) the “open account” option.

Question 15: In which of the following situations would a seller grant consignmentterms? (Select all that apply.)

_____ a) Reputable consignee who is unknown to the seller

_____ b) Between buyers and sellers with excellent long-term relationships

_____ c) Between parent companies and subsidiaries to facilitate intra-company trade

_____ d) Consignee with whom the seller has a good credit history andwhose country faces economic and political stability

Question 16: Chemco, one of the largest Mexican producers and exporters of chemicalproducts, is scheduled to begin selling phosphate to QRS Chemicals, acompany recently acquired by Chemco. In arranging financing terms,Chemco has offered its subsidiary a tenor of up to 90 days after shipmentdate. What is the best payment option for this trade arrangement?

_____ a) Export Letter of Credit

_____ b) Import Letter of Credit

_____ c) Open Account


_____ e) Documentary Collection

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ANSWER KEY

Question 14: Banks acting as intermediaries of a trade transaction can derive more feeincome from:

b) documents against acceptance.

Question 15: In which of the following situations would a seller grant consignmentterms? (Select all that apply.)

d) Consignee with whom the seller has a good credit history andwhose country faces economic and political stability

Question 16: Chemco, one of the largest Mexican producers and exporters of chemicalproducts, is scheduled to begin selling phosphate to QRS Chemicals, acompany recently acquired by Chemco. In arranging financing terms,Chemco has offered its subsidiary a tenor of up to 90 days after shipmentdate. What is the best payment option for this trade arrangement?

c) Open Account

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LETTERS OF CREDIT (L/C)

Bank assumesobligation to pay

The fifth major payment option covered in this unit, “letter ofcredit,” is an instrument issued by a bank to a named party whichsubstitutes the bank’s creditworthiness for that of its customer.The letter of credit states the bank’s willingness to guarantee itscustomer’s credit and the bank’s conditional obligation to pay theparty named in the letter of credit.

Parties to a Letter of Credit

Several participants are involved in a letter of credit transaction:

n The applicant is the party that arranges for the letter ofcredit to be issued.

n The beneficiary is the party named in the letter of credit inwhose favor the letter of credit is issued.

n The issuing or opening bank is the applicant’s bank thatissues or opens the letter of credit in favor of the beneficiaryand substitutes its creditworthiness for that of the applicant.

n An advising bank may be named in the letter of credit toadvise the beneficiary that the letter of credit was issued.

n The paying bank is the bank nominated in the letter ofcredit that makes payment to the beneficiary withoutrecourse, after determining that documents conform, andupon receipt of funds from the issuing bank or anotherintermediary bank nominated by the issuing bank.

n The confirming bank is the bank which, under instructionfrom the issuing bank, substitutes its creditworthiness for thatof the issuing bank. It ultimately assumes the issuing bank’scommitment to pay.

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Citibank’s role A bank may take on more than one role in a single letter of credittransaction. At least two banks are involved in most transactions —the bank in the applicant’s country and the bank in the beneficiary’scountry. However, it is not unusual to find three, and sometimesfour, different banks participating in one transaction. As a resultof Citibank’s global network, Citibank can assume many roles ina single transaction. In a letter of credit transaction, banks deal onlywith documents; they have nothing to do with the goods.

Revocable or Irrevocable Letter of Credit

Letters of credit are issued either as “revocable” or “irrevocable.”Unless clearly designated revocable, a letter of credit is consideredirrevocable.

Amended orcanceled atany time

A revocable letter of credit is one that can be amended or canceledby the issuing or opening bank at any time without prior notice to,or agreement of, the beneficiary. It is seldom used.

Cannot beamended orcanceled

An irrevocable letter of credit is one that is a definite commitmentby the issuing bank to pay, provided the beneficiary complies withthe terms and conditions of the letter of credit. An irrevocable letterof credit cannot be amended or canceled without the consent of theissuing bank, confirming bank (if the L/C is confirmed), and thebeneficiary.

Basic Letter of Credit Components

Requiredinformation

A letter of credit always includes the following basic components:

n Revocable or irrevocable designation

n Beneficiary’s name and address

n Aggregate amount in the specified currency.Letters of credit can be issued in any currency.

n Expiration date and place of expiration

n Payment terms and conditions

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Discrepancy Documents must comply with the terms and conditions of the letterof credit and must be consistent with all documentary requirements.A discrepancy represents any variation or difference between therequirements of the credit (text) and what is shown on thedocuments presented.

A discrepancy can void the bank’s commitment to pay. In somecases, the bank may return the discrepant documents to thebeneficiary with instructions to re-present corrected documents. Ifthe beneficiary cannot re-present corrected documents, the payingbank, on the instruction of the beneficiary, requests approval fromthe issuing bank to waive the discrepancies and pay the beneficiary.

In the event that the issuing bank refuses to waive the discrepancies,the beneficiary retains the ownership of the shipping documents andmay seek settlement outside of the letter of credit.

COMMERCIAL AND STANDBY LETTERS OF CREDIT

Payment forgoods vs.payment forperformance

The characteristics that we have described so far are common to anyletter of credit; however, there are two major categories of letters ofcredit – commercial letters of credit and standby letters of credit.A commercial letter of credit is used as a payment method inconjunction with the movement of goods. A standby letter of creditis used as a monetary indemnification in relation to the performanceof the Bank’s customer in an underlying contractual obligation withanother party. We describe these two types of letters of credit in thepages that follow.

References There are two publications published by the International Chamberof Commerce (ICC) which provide guidelines for parties /participants in letter of credit transactions: the Uniform Customsand Practice for Documentary Credits (UCP) and theInternational Standby Practices (ISP). While the UCP is utilizedfor both commercial letters of credit and standby letters of credit, theISP is a more recent publication specifically suited and moreappropriate to use for standby letters of credit.

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Commercial Letters of Credit

When the beneficiary (seller or exporter) is in a position to dictateterms that minimize risk, and the applicant (buyer or importer)wishes to purchase goods without paying for them in advance, thebeneficiary will require the applicant to provide a commercial letterof credit.

A commercial letter of credit is an instrument that states the bank’sobligation to pay the beneficiary upon presentation of conformingdocuments evidencing that goods have been shipped. Citibank onlypays the beneficiary if the required documents presented are inaccordance with the terms and conditions of the letter of credit.

Other terms In addition to the basic letter of credit components previouslydescribed, the following terms and conditions are also part of acommercial letter of credit:

n Presentation period for documents

n Latest shipment date

n Required documentation

n Merchandise description

n Origin of goods, place of shipment and destination, shippingterms (i.e. FOB, FCA, CFR, CIF please refer to the latestedition of the ICC publication titled INCOTERMS 1990)

n Reimbursement instructions (for bank use only)

Transactionflow

The typical transaction flow of a commercial letter of credit is asfollows:

1. The applicant (buyer or importer) initiates the request fora letter of credit.

2. The issuing bank (opening) issues the letter of credit andforwards it to the beneficiary directly or transmits it to theadvising bank.

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3. The advising bank authenticates and presents the letter ofcredit to the beneficiary. If the issuing bank nominates theadvising bank to be its paying agent, the advising bank mayalso become the paying bank. The issuing bank may alsorequest that the advising bank add its confirmation to theletter of credit.

4. The beneficiary ships the goods.

5. The beneficiary forwards the documents required under theterms and conditions of the letter of credit to the paying(confirming) bank.

6. The paying (confirming) bank examines the documents toensure compliance with the terms and conditions of the letterof credit. If the documents comply, the paying bank receivesfunds from the issuing bank before releasing payment to thebeneficiary.

7. The paying (confirming) bank forwards the documents to theissuing bank. Upon receipt, the issuing bank reexamines thedocuments to ensure compliance with the terms andconditions of the letter of credit.

8. The issuing bank debits the applicant’s account.

9. The issuing bank releases the documents to the applicant.

The commercial letter of credit flow is illustrated in Figure 2.8.

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Figure 2.8: Commercial letter of credit flow

Settlements Under a Letter of Credit

All commercial letters of credit must clearly indicate whether theyare payable by sight payment, by deferred payment, by acceptance,or by negotiation. These are noted as formal demands under theterms of the commercial letter of credit.

Sight payment In a sight payment, the commercial letter of credit is payablewhen the beneficiary presents the complying documents and ifthe presentation takes place on or before the expiration of thecommercial letter of credit.

Deferredpayment

In a deferred payment, the commercial letter of credit is payable ona specified future date. The beneficiary may present the complyingdocuments at an earlier date, but the commercial letter of credit ispayable only on the specified future date.

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Acceptance An acceptance is a time draft drawn on, and accepted by, a bankinginstitution which promises to honor the draft at a specified futuredate. The act of acceptance is without recourse as it is a commitmentto pay the face amount of the accepted draft.

Negotiation Under negotiation, the negotiating bank, a third party negotiator,expedites payment to the beneficiary upon the beneficiary’spresentation of the complying documents to the negotiating bank.The bank pays the beneficiary, normally at a discount of the faceamount of the value of the documents, and then presents thecomplying documents, including a sight or time draft, to the issuingbank to receive full payment at sight or at a specified future date.

Types of Irrevocable Commercial Letters of Credit

There are three basic types of irrevocable commercial lettersof credit.

1. Straight letter of credit

A straight letter of credit usually involves three parties:an applicant, the issuing bank, and the beneficiary. Thecommitment of the issuing bank extends to the namedbeneficiary; the beneficiary presents the documents directlyto the issuing bank or nominated paying bank for payment.

2. Negotiable letter of credit

In a negotiable letter of credit, the issuing bank assures anyonewho “negotiates” against conforming documents that it will bereimbursed under the terms and conditions of the letter of credit.The negotiating bank becomes a legal party to the letter of credit.

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Additionalparty:negotiating bank

In a negotiable letter of credit, the additional party to consideris the negotiating bank. This bank, usually unnamed in the letterof credit, elects to “negotiate” (purchase documents from, andadvance funds to, the beneficiary) against presentation of thedocuments required by, and conforming to, the terms andconditions of the letter of credit.

Settlementunder negotiableletter of credit

Generally, a negotiating bank negotiates documents and mayprovide advance funding to the beneficiary on a recourse basis.In effect, the negotiating bank extends a loan and charges a fee.If the issuing bank refuses to reimburse the negotiating bank forreasons other than discrepant documents, the negotiating bankcan retrieve its funds from the beneficiary. From the beneficiary’sperspective, a negotiable letter of credit accelerates payment.

3. Confirmed letter of credit

A confirmed letter of credit is typically used when abeneficiary may not be willing to rely on the credit standing(creditworthiness) of an issuing bank and/or on the politicalrisk of the issuing bank’s country. The risks associated with theissuing bank’s country may affect the ability of the issuing bankto honor its obligations.

Commitment topay withoutrecourse

As a result, the beneficiary may insist not only that the issuingbank issues a letter of credit, but also may require that a bank inthe beneficiary’s country adds its commitment to pay withoutrecourse. This requirement is met by a letter of credit that is anirrevocable obligation of the issuing bank (buyer’s bank) whichis confirmed by a bank in the beneficiary’s country. The bankin the beneficiary’s country adds its commitment to that ofthe issuing bank to honor drafts and documents presented inaccordance with the terms and conditions of the letter of credit.This bank is referred to as the confirming bank.

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Confirmed,irrevocable letterof creditprovides bestprotectionto beneficiary

The confirming bank guarantees payment and assumes the creditand country risks of the issuing bank. A confirmed, irrevocableletter of credit provides the best protection to the beneficiary inmitigating the cross-border and commercial risks of thetransaction.

Special Features of Commercial Letters of Credit

Letters of credit may be structured to meet the particularcircumstances of a transaction. Some special features include:revolving, red clause, back-to-back, transferable letters ofcredit, and assignment of proceeds.

n Revolving Letters of Credit Credit availablefor fixed amountof time

Instead of establishing one letter of credit for each shipmentfrom the same seller, the buyer can open a revolving letterof credit which makes a fixed sum available for a specifiedamount of time to cover multiple shipments from a single seller.For example, a letter of credit with a total value of $600,000may be structured to allow a seller to make six monthlyshipments, each valued at $100,000. The seller may draw upto $100,000 after each shipment.

Cumulative /non-cumulative

Revolving letters of credit may be cumulative or non-cumulative. In a cumulative revolving letter of credit, the$100,000 per month may be carried over into another month if,for some reason, the seller does not ship. In a non-cumulativerevolving letter of credit, the $100,000 does not carry over frommonth to month.

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n Red Clause Letters of Credit Cash advance(loan) tobeneficiary

In this type of letter of credit, the buyer / applicant authorizesthe designated bank to make a cash advance (loan) to the seller /beneficiary to purchase the goods or effect shipment under theletter of credit. The designated bank charges interest to the sellerat the local rate, unless the letter of credit terms provideotherwise.

It is referred to as a “red clause” simply because some bankshistorically printed this clause in red ink. Typically, it is usedwhen the applicant and the beneficiary enjoy a close businessrelationship.

n Back-to-Back Letters of Credit Possiblecollateral forsecond L/C

Two letters of credit used to facilitate the purchase of the samegoods are called back-to-back letters of credit. The beneficiaryof an irrevocable letter of credit may use it as collateral to opena second letter of credit. This second letter of credit is issued infavor of the ultimate manufacturer or supplier of goods neededfor shipment under the first letter of credit.

In a back-to-back letter of credit, the beneficiary of the first letterof credit provides security for his/her supplier by procuring theissuance, in favor of the supplier, of a second letter of credit.

A back-to-back letter of credit is an instrument seldom usedbecause of the credit and operational risks for the paying /confirming bank of the first (original) letter of credit. This bankbecomes, in turn, the opening bank of the second letter of credit.Some of the problems with this instrument are as follows:

• The credit standing of the original beneficiary must besuch to enable the original paying / confirming bank toopen the second letter of credit without requiring anycollateral dependency on the first letter of credit.

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• The terms and conditions of the first and second lettersof credit should NOT be mirrored. For instance, theexpiration date of the second letter of credit wouldneed to be several days less than the first letter ofcredit to accommodate the two presentations ofdocuments.

• There are issues involving the original beneficiary. Forinstance, suppose the second beneficiary presents thedocuments which meet the terms and conditions of thesecond letter of credit. As a result, the opening bank ofthe second letter of credit must pay.

• Now, what happens if the original beneficiary does notpresent the documents or goes bankrupt? What if theoriginal opening bank finds discrepancies with thepresented documents and refuses to pay? How will theopening bank of the second letter of credit getreimbursed by the opening bank of the first letter ofcredit?

Whenever a “transferable” credit is necessary to execute a tradetransaction, there are other instruments available that minimize abank’s risk. These are transferable letters of credit andassignment of proceeds.

n Transferable Letters of Credit Transfers creditto supplier

A transferable letter of credit involves less risk for the Bank thanto a back-to-back letter of credit. It allows the beneficiary of thetransferable letter of credit to request the nominated transferringbank to transfer, in whole or in part, the letter of credit to one ormore second beneficiary(ies). The first beneficiary is typicallya broker or middle person in the transaction and the secondbeneficiary(ies) is the ultimate supplier of the goods.

n Assignment of Proceeds

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Assignmentof proceeds toa third party

If the letter of credit is not transferable, an assignment ofproceeds is another option available for the beneficiary to financethe purchase of goods from its supplier. With assignment ofproceeds and in accordance with the provisions of applicablelaw, the beneficiary can instruct the paying bank to assign,partiallyor in total, the proceeds available under a letter of credit to athird party (assignee).

The assignment of proceeds is not, itself, a letter of credit andthe assignee is not a party to the letter of credit. The assigneeis not entitled to payment under the letter of credit unless thebeneficiary presents strictly complying documents under theterms and conditions of the letter of credit. If the beneficiary failsto submit complying documents, the assignee will not be paid theamount originally agreed to under the assignment of proceeds.

Advantages and Risks of Commercial Letters ofCredit

Applicant’sadvantagesand risks

The letter of credit assures the applicant (buyer) that the beneficiary(seller) will only be paid if the documents comply with the termsand conditions stated in the letter of credit. Since banks only dealwith documents, and not with goods, the applicant still runs the riskthat the merchandise may not be as it was represented in thedocumentation.

Beneficiary’sadvantagesand risks

The beneficiary enjoys four major advantages with a commercialletter of credit:

1. The beneficiary is assured of payment as long as it complieswith the terms and conditions of the letter of credit. The letterof credit identifies which documents must be presented andthe data content of those documents. The credit risk istransferred from the applicant to the issuing bank.

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2. The beneficiary can enjoy the advantage of mitigating theissuing bank’s country risk by requiring that the letter ofcredit be confirmed by a bank in its own country. That bankthen takes on the country and commercial risk of the issuingbank and protects the beneficiary.

3. The beneficiary minimizes collection time as the letter ofcredit accelerates payment of the receivables.

4. The beneficiary’s foreign exchange risk is eliminated witha letter of credit issued in the currency of the beneficiary’scountry.

Citibank’s risks In addition to operational risks, Citibank can incur other risksdepending on the role(s) it plays in a letter of credit transaction.The roles and corresponding risks are as follows:

n Issuing Bank — faces a credit risk, as the bank thatsubstitutes its creditworthiness for that of its customer. Theissuing bank takes the full risk of the transaction until itscustomer, the applicant, is able to repay the full amount of thepayment under the letter of credit.

Operational risks also are associated with the issuing bankbecause the bank may misinterpret or overlook part of theapplicant’s (customer’s) instructions. For instance, whenthe issuing bank opens the letter of credit, it may forget toinclude a beneficiary documentation requirement that hadbeen specified as part of the applicant’s original instructionsto the issuing bank. As a result, the beneficiary may get paid,but the issuing bank may not be able to be reimbursed by theapplicant because the documentation requirements do notcomply with the applicant’s original instructions.

n Advising Bank — faces operational risks such as delayingor failing to advise the beneficiary that a letter of credit hasbeen issued. As a result, the letter of credit may expire orthere may be insufficient time for the beneficiary to presentthe documentation under the terms and conditions of theletter of credit. In addition, the advising bank can be liablefor failure to properly authenticate the apparent authenticityof the letter of credit.

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n Paying Bank — faces operational risks such as paying thebeneficiary against nonconforming documents.

n Confirming Bank — faces a credit risk as the bank thatsubstitutes its creditworthiness for that of the issuing bank.The confirming bank takes the full risk of the transactionuntil its customer, the issuing bank, reimburses the fullamount of the payment under the letter of credit. It also facesoperational risks such as payment against nonconformingdocuments, and country risk of the issuing bank’s country.

n Negotiating Bank — faces operational risks such as paymentagainst nonconforming documents or misplacing anydocumentation that must be returned to the issuing bank.It also faces the credit risk of the beneficiary when advancingfunds with recourse to the exporter.

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The advantages and risks of a commercial letter of credit for theapplicant, beneficiary, and Citibank are shown in Figure 2.9.

COMMERCIAL LETTER OF CREDIT

Goods are shipped to the applicant. The beneficiary’s draft and titledocuments are presented through the paying / confirming / issuing

bank for payment.

Advantages Risks

APPLICANT n Assurance thatpaymentwill only be made uponbeneficiary’scompliance with L/Cterms and conditions

n Merchandise not asrepresented in documentation

BENEFICIARY n Mitigation ofcommercial andcountry risks, if creditis confirmed

n Currency conversionapproved beforegoods shipped

n Collection timeminimized

n Elimination of foreignexchange risk for L/Cissued in currency ofbeneficiary’s country

n Non-compliance with L/C termsand conditions

CITIBANK

(Risks may varydepending onbank role)

n Fee-based revenuesn Cross-sell opportunities

n Issuing Bank – credit risk of theapplicant and operational risks

n Advising Bank – operationalrisks

n Paying Bank – operationalrisks

n Confirming Bank – credit riskof the issuing bank, operationalrisks, and country risk of theissuing bank’s country

n Negotiating Bank – operationalrisks; credit risk of thebeneficiary

Figure 2.9: Commercial letter of credit: Advantages and risks for applicant,beneficiary, and Citibank

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Import Letter of Credit and Export Letter of Credit

The same letter of credit can be viewed as either an import oran export letter of credit, depending on the customer’s role inthe trade transaction. For the applicant (importer or buyer), it isan import letter of credit; for the beneficiary (exporter or seller),it is an export letter of credit.

Import Letterof Credit

From the importer’s or applicant’s perspective, the issuing bank(local bank) issues an import letter of credit for the account of theapplicant (local importer or buyer), in favor of the beneficiary(foreign seller), to secure payment for foreign goods purchased.

Export Letterof Credit

From the exporter’s perspective, it is the same (import) letter ofcredit opened by the issuing bank on behalf of the beneficiary. Thisletter of credit is viewed by the advising / confirming / paying /negotiating bank as an export letter of credit for the account of anoverseas buyer of the exporter’s goods, in favor of the exporter, aspayment for goods purchased.

The differences between the two perspectives are shown in Figure2.10.

IMPORTLetter of Credit

EXPORTLetter of Credit

Customer’s Role Applicant(Importer)

Beneficiary(Exporter)

L/C Opened by Applicant’s bank

For the Account of Applicant

In Favor of Beneficiary

As Payment for Foreign goodspurchased

Local goods sold

Figure 2.10: Import Letter of Credit vs. Export Letter of Credit

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Standby Letters of Credit

The second major category of letter of credit, standby letter of credit,is an instrument that secures the beneficiary against loss resultingfrom the failure of the bank’s customer to perform a contractualobligation, financial or nonfinancial, that the customer has with thebeneficiary. This means that the bank promises to make a monetarypayment under certain conditions specified in the letter of credit.

While a commercial letter of credit is usually payable against thepresentation of specified documents evidencing the shipment ofgoods, documents required in a standby letter of credit may consistsimply of the beneficiary’s statement that the bank’s customerhas defaulted in certain obligations that the customer has with thebeneficiary. The bank does not investigate the underlying facts ofthe transaction and it pays against documents only.

Standby letters of credit typically do not require the submission ofshipping documents and are rarely used as a payment mechanismfor the movement of goods.

Other terms In addition to the basic letter of credit components previouslydescribed, the following terms and conditions are also part of astandby letter of credit:

n Required documentation

n Reimbursement instructions (for bank use only)

Types of standbyletters of credit

There are two basic types of standby letters of credit issued eitheras revocable or irrevocable: guarantee and payment. They areoutlined in Figure 2.11, page 2-50. Later we will describe otherlegal forms of guarantee that are commonly used outside the USin place of a standby letter of credit.

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Standby Letter of Credit: Guarantee Type

Form ofprotectionto coverperformanceunder acontract

The guarantee type standby letter of credit, issued only asirrevocable, may be used as a form of protection to coverperformance, financial or nonfinancial obligation, under a contract.This instrument protects the beneficiary financially in the event thatthe bank’s customer fails to perform under the contract mentionedin the letter of credit. Otherwise, the beneficiary may draw thosefunds available under the letter of credit. It is referred to as a“standby” letter of credit because it provides financial protection tothe beneficiary if the applicant defaults on the terms of the contractor agreement.

The guarantee type can be used in just about any businesstransaction that requires a financial indemnification such as:

n In lieu of bid, performance, and surety bonds

n In lieu of bank guarantees

n To support another bank’s guarantee or undertaking

n To provide security for advance payments

Example ofsecurity foradvancepayments

Suppose a government agency advances $1 million to a constructioncompany for materials to build a hospital. The government agencyrequires the contractor to have its bankissue a standby letter of credit to cover the advance in case thecontractor goes out of business or disappears with the money.If the contractor defaults, the agency can draw the $1 million fromthe contractor’s bank under the standby letter of credit. Ifthe contractor performs as expected, the agency never draws underthe letter of credit.

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Standby Letter of Credit: Payment Type

Functionsas a paymentmechanismfor differentconditions

The payment type standby letter of credit functions as a paymentmechanism under specified terms and conditions. Payment may betriggered by virtually any mechanism agreed upon by the applicantand the beneficiary.

A standby letter of credit issued as a payment vehicle can be eitherrevocable or irrevocable, depending on the applicant’s objective.

n If revocable, the payment under the standby letter of creditmay be issued to cover:

• Salary payments

• Intercompany payments

• Expense payments

n If irrevocable, the payment under the standby letter of creditmay be issued:

• As payment of principal and/or interest on bonds

• In lieu of stock transfer contracts

A stock transfer contract refers to those transactions inwhich the securities holder wishes to contract for thesale of securities, at a selling price established today,with delivery and payment to be made at a future date.If the beneficiary (securities holder) presentsconforming documents (e.g., sight draft along with theendorsed securities), the standby letter of credit assuresthat the beneficiary will be paid.

• To pay progress payments

• To pay any type of periodic payment obligation(e.g. rent, lease, alimony, insurance premiums)

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Figure 2.11: Types of Standby Letters of Credit

Standby Letters of Credit

Guarantee Irrevocable

Revocable

Payment of Principal and/orInterest on Bonds

In Lieu of Stock TransferContracts

To Pay Progress Payments

To Pay Any Type of PeriodicPayment Obligation

Irrevocable

Payment Type

Salary Payments (Abroad)

Intercompany Payments

Expense Payments

In Lieu of Bid, Performanceand Surety Bonds

In Lieu ofBank Guarantees

To Support Another Bank’sGuarantee of Undertaking

To Provide Security forAdvance Payments

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Advantages and Risks of Standby Letters of Credit

Applicant’sadvantagesand risks

Some of the advantages of a standby letter of credit for the applicantare as follows:

n The applicant may not have to commit funds to collaterizethe transaction.

n The instrument is widely accepted in the marketplace asa financial indemnity.

n The instrument is less costly than other indemnificationinstruments such as surety bonds.

The applicant will always run the risk that the beneficiary may notperform honestly, ethically and legally. The applicant has to acceptthe risk of the beneficiary’s integrity.

Beneficiary’sadvantages

The beneficiary enjoys three major advantages with a letter ofcredit:

1. The beneficiary may enjoy the advantage of mitigating theissuing bank’s country risk by requiring that the letter of creditbe confirmed by a bank in its own country. That bank thentakes on the country and commercial risk of the issuing bank.

2. The beneficiary’s foreign exchange risk is eliminated with a letterof credit issued in the currency of the beneficiary’s country.

3. The beneficiary is assured of payment as long as it complies withthe terms and conditions of the letter of credit. The letter of creditidentifies which documents must be presented and the datacontent of those documents. The credit risk is transferred fromthe applicant to the issuing bank.

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Citibank’s risks In addition to operational risks, Citibank can incur other risksdepending on the role(s) played by Citibank in a standby letter ofcredit transaction. The roles and corresponding risks are as follows:

n Issuing Bank — faces a credit risk, as the bank thatsubstitutes its creditworthiness for that of its customer.The issuing bank takes the full risk of the transaction untilits customer, the applicant, is able to repay the full amountof the payment under the letter of credit.

n Advising Bank — faces operational risks such as delayingor failing to advise the beneficiary that a letter of credit hasbeen issued. As a result, the letter of credit may expire orthere may be insufficient time for the beneficiary to presentthe documentation under the terms and conditions of theletter of credit. In addition, the advising bank can be liablefor failure to properly authenticate the letter of credit.

n Paying Bank — faces operational risks such as paying thebeneficiary against nonconforming documents.

n Confirming Bank — faces a credit risk since the confirmingbank takes the full risk of the transaction until its customer,the issuing bank, reimburses the full amount of the paymentunder the letter of credit. It also incurs operational risks andcountry risks of the issuing bank’s country.

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The advantages and risks of a standby letter of credit for the applicant,beneficiary and Citibank are shown in Figure 2.12.

STANDBY LETTER OF CREDIT

The beneficiary’s draft and documents are presented through thepaying / confirming / issuing bank for payment.

Advantages Risks

APPLICANT n May not need to commitfunds to collaterize thetransaction

n Instrument widely acceptedin the marketplace

n Instrument less expensivethan other indemnificationinstruments

n Beneficiary may drawprematurely or presentfraudulent documents

BENEFICIARY n Mitigation of commercialand country risks, if credit isconfirmed

n Elimination of foreignexchange risk for L/C issuedin currency of beneficiary’scountry

n In case of default, ease ofpayment settlement

n Non-compliance with L/Cterms and conditions

CITIBANK

(Risks may varydepending onbank role)

n Fee-based revenues

n Cross-sell opportunities

n Issuing Bank – credit riskof the applicant;operational risks

n Advising Bank –operational risks

n Paying Bank – operationalrisks

n Confirming Bank – creditrisk of the issuing bank,operational risks, andcountry risk of the issuingbank’s country

Figure 2.12: Standby letter of credit: Advantages and risks for applicant,beneficiary and Citibank

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Other Legal Forms of Guarantee

Legal forms ofguarantee:bonds vs. lettersof guarantee

There are different legal forms of guarantee issued by banks locatedoutside the US – bonds and (letters of) guarantee. These instrumentsrepresent the issuing bank’s commitment, made at the request of itscustomer, to pay a third party upon the occurrence of an assuredevent. They are contingent liabilities of the bank, which becomeabsolute liabilities when the stated contingency occurs.

In the event an appropriate claim for payment is made, the bankmakes payment and seeks reimbursement from its customer. Byissuing the guarantee, the bank substitutes its creditworthiness forthat of its customer.

Although the terms bond and (letters of) guarantee may be usedinterchangeably, there are some distinctions:

n A letter of guarantee or guarantee is a promise madeby one party (the bank) on behalf of some other party (thebank’s customer and principal) that payment will be made toa third party (the obligee) at some future date. In the eventthat the bank’s customer does not make good its obligation topay, the bank undertakes that it will make such payment.Guarantees are generally issued to assure financial, ratherthan nonfinancial contractual, obligations.

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n A bond is a commitment made by one party (the bank) toanother party (the obligee) pledging to cover for financialloss caused by the act of default of a third party (the obligor –the bank’s customer). A bond is normally issued to assureperformance of a nonfinancial contractual obligation, e.g. anobligation to provide goods or services under a contract withanother party. Some of the common types of bonds are:

• Bid bond – an instrument designed to ensurethat the tenderer (e.g., supplier) will honor itscommitment to a buyer when bidding for aconstruction or supply contract. The tenderersubmitting a bid requests its bank to issue a bid bondin favor of the buyer as beneficiary. In the event thetenderer’s bid is accepted and the tenderer fails to signthe contract, the bid bond is normally payable againstthe buyer’s statement that the bank’s customer, thetenderer, failed to sign the contract.

• Performance bond – issued when the contract hasbeen awarded. It is an instrument designed to ensurethat the contractor (e.g. supplier) will perform andexecute the contract in accordance with all its termsand conditions. A performance bond gives the buyeran indication of the contractor’s creditworthiness and,in the case of default, is payable on demand.

• Surety bond – designed to ensure financialcompensation to the buyer if the supplier does notperform contractually as agreed. It is an instrumentissued by insurance and surety companies for oneof the parties involved in a contract, arbitration, andjudgment who is required to post bond.

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Letters ofGuarantee vs.Standby Letterof Credit

Whether for an advance payment guarantee or bond (e.g., thecontractor requires an advance payment on the contract price tofinance operations), bid bond, or performance bond, the (letterof) guarantee is the instrument of preference in many countries.Although banks in the United States are not permitted to providebank (letters of ) guarantee, they are allowed by the regulatoryagencies to substitute standby letters of credit in lieu of (lettersof) guarantee, mitigating what would otherwise be a seriousshortcoming for US exporters.

When a guarantee is required, the US bank can ask its foreignsubsidiary, branch, or correspondent bank to open a (letter of)guarantee on the US bank’s behalf. The US bank then backs up itsrequest for a (letter of) guarantee from the foreign bank with its ownstandby letter of credit.

The terms and conditions stated in a standby letter of credit arecritical to the document. If they are not clearly defined and a disputearises between the beneficiary and the bank’s customer, then thebank may have to play the difficult role of arbitrator. To avoid such aposition, standby letters of credit, unlike a bank (letter of) guarantee,always include very specific instructions which define all of theprerequisites for drawing against the standby letter of credit.

We have described certain legal forms of guarantee that arecommonly used outside the US in place of a standby letter of credit.Note that these other forms of guarantee are not usually issued byCitibank.

Summary

A letter of credit is an instrument that substitutes a bank’s credit-worthiness for that of its customer, the applicant. It also provides thebank’s conditional obligation to pay the party named in the letter ofcredit (the beneficiary). The letter of credit offers a certain degree ofprotection to both parties, applicant and beneficiary; hence, it is thepreferred payment mechanism in trade.

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A letter of credit may be issued either in revocable or irrevocableform and will be considered irrevocable if it is not clearly designatedas one or the other. A revocable letter of credit may be altered orcanceled by the issuing bank at any time; an irrevocable letter ofcredit cannot be amended or canceled without the expresspermission of the parties involved – beneficiary and intermediarybanks.

A letter of credit assures the applicant that the beneficiary will onlybe paid if the documents presented by the beneficiary comply withthe terms and conditions of the letter of credit.

If the beneficiary complies exactly with the terms and conditionsof the letter of credit, and if the letter of credit is confirmed, thebeneficiary will be protected against the applicant’s credit riskand the issuing bank’s country and credit risks. When the letter ofcredit is issued in the currency of the beneficiary’s country, thebeneficiary is protected against foreign exchange and cross-border(transfer and convertibility) risk. (Transfer and convertibility risksare covered in more detail in Unit 4.)

A bank incurs operational risks and any other risk depending on therole(s) played in a letter of credit transaction. As the issuing bank, itfaces the applicant’s credit risk; as the advising / negotiating /paying bank, it faces operational risks; and as the confirming bank, itfaces the issuing bank’s credit and country risks.

The applicant of a letter of credit has the advantage of not alwaysneeding to commit funds to collaterize the transaction and enjoyingthe use of an instrument which is widely accepted in the marketplaceand less costly than other indemnification instruments. However, theapplicant runs the risk that the beneficiary may draw prematurely orpresent fraudulent documents.

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In terms of the beneficiary’s advantages, when the beneficiarysubmits documents in accordance with the terms and conditionsof the letter of credit, the bank becomes obligated to pay. Thebeneficiary can mitigate the issuing bank’s country risk by requiringthat the letter of credit be confirmed by a bank in its own country.If the letter of credit is issued in the currency of the beneficiary’scountry, the beneficiary also eliminates its foreign exchange risk.

In this section we examined the differences between the two majorcategories of letters of credit, commercial and standby.

A commercial letter of credit is used to facilitate the payment ofgoods in a trade transaction. It is essentially an agreement wherebya bank assumes a conditional obligation, in behalf of the applicant(buyer or importer), to make payment to a beneficiary (seller orexporter) against the presentation of specified documents by thebeneficiary evidencing the shipment of goods.

A standby letter of credit is used as a monetary indemnificationassociated with the performance of the bank’s customer in relationto an underlying contractual obligation with a third party. It protectsa third party, the beneficiary, from loss resulting from the failure ofa bank’s customer, the applicant, in performing some contractualobligation.

To check your understanding of the fifth trade payment option, letters of credit, pleasecomplete Progress Check 2.2 and check your answers with the Answer Key. If youanswer any questions incorrectly, please reread the corresponding text to clarify yourunderstanding. Then, proceed to the final section of Unit 2, “Financial and CommercialTransaction Documents,” where you will learn about different types of trade documents.

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Question 1: Which party typically adds its promise to pay under a confirmed letterof credit?

_____ a) Buyer

_____ b) Bank in the beneficiary’s country

_____ c) Bank that issued the letter of credit

_____ d) Beneficiary

Question 2: Typically, under what conditions will the paying bank pay the seller under acommercial letter of credit? (Select all that apply.)

_____ a) Seller presents to the paying bank the documents that meet the L/Cterms and conditions

_____ b) Buyer confirms receipt of the goods

_____ c) Buyer presents the title document and guarantees to the issuing bank

_____ d) Buyer places sufficient funds in his or her account with the issuing bank

_____ e) Paying bank receives funds from issuing bank or its agent bank

Question 3: The best protection for the seller is provided by a(n):

_____ a) straight letter of credit.

_____ b) open account.

_____ c) revolving letter of credit.

_____ d) confirmed, irrevocable letter of credit.

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ANSWER KEY

Question 1: Which party typically adds its promise to pay under a confirmed letterof credit?

b) Bank in the beneficiary’s country

Question 2: Typically, under what conditions will the paying bank pay the seller under acommercial letter of credit? (Select all that apply.)

a) Seller presents to the paying bank the documents that meet the L/Cterms and conditions

e) Paying bank receives funds from issuing bank or its agent bank

Question 3: The best protection for the seller is provided by a(n):

d) confirmed, irrevocable letter of credit.

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Question 4: Identify the type of commercial letter of credit used by an importer withmultiple scheduled payments:

_____ a) Revolving, irrevocable letter of credit

_____ b) Confirmed, irrevocable letter of credit

_____ c) Negotiable, import letter of credit

_____ d) Red clause, straight letter of credit

Question 5: A commercial letter of credit whereby the beneficiary has the right torequest that it be made available to one or more parties and is less riskyto the nominated advisory / confirming bank, is known as a:

_____ a) red clause letter of credit.

_____ b) transferable letter of credit.

_____ c) back-to-back letter of credit.

_____ d) clean letter of credit.

Question 6: In a letter of credit, banks deal:

_____ a) only in goods, not with documents.

_____ b) only with documents, not in goods.

_____ c) with documents and in goods.

_____ d) only with documents, not in goods, as long as it is a standby letterof credit

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ANSWER KEY

Question 4: Identify the type of commercial letter of credit used by an importer withmultiple scheduled payments:

a) Revolving, irrevocable letter of credit

Question 5: A commercial letter of credit whereby the beneficiary has the right torequest that it be made available to one or more parties and is less riskyto the nominated advisory / confirming bank, is known as a:

b) transferable letter of credit.

Question 6: In a letter of credit, banks deal:

b) only with documents, not in goods.

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Question 7: In a straight letter of credit, the parties involved are always the:

_____ a) applicant, issuing bank, and beneficiary.

_____ b) applicant, issuing bank, paying bank, and beneficiary.

_____ c) applicant, issuing bank, negotiating bank, and beneficiary.

_____ d) applicant, issuing bank, advising bank, and beneficiary.

Question 8: An exporter and importer are about to close a large trade deal but theissuing bank is unknown to the exporter. What commercial letter ofcredit would best meet the needs of the exporter to minimize its risk?

_____ a) Negotiable

_____ b) Confirmed

_____ c) Straight

_____ d) Back-to-Back

Question 9: For each role that a bank plays in a commercial letter of credit, identifyone or more of the most common risks associated with the role.

_____ a) Issuing Bank 1. Credit risk of the applicant

_____ b) Advising Bank 2. Operational risk

_____ c) Paying Bank 3. Credit risk of the issuing bank

_____ d) Negotiating Bank 4. Foreign exchange risk

_____ e) Confirming Bank 5. Interest rate risk

6. Political risk

7. Credit risk of the beneficiary

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ANSWER KEY

Question 7: In a straight letter of credit, the parties involved are always the:

a) applicant, issuing bank, and beneficiary.

Question 8: An exporter and importer are about to close a large trade deal but theissuing bank is unknown to the exporter. What commercial letter ofcredit would best meet the needs of the exporter to minimize its risk?

b) Confirmed

Question 9: For each role that a bank plays in a commercial letter of credit, identifyone or more of the most common risks associated with the role.

1,2_ a) Issuing Bank: Credit risk of the applicant, Operational risk

2 _ b) Advising Bank: Operational risk

2 _ c) Paying Bank: Operational risk

2,7_ d) Negotiating Bank: Operational risk, Credit risk of the beneficiary

2,3,6 e) Confirming Bank: Operational risk, Credit risk of theissuing bank, Political risk

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Question 10: A seller, who will have a letter of credit opened in his favor, does nothave funds to purchase the goods from his supplier and does not qualify fora bank loan. What would be the least complicated letter of credit to beissued that would enable the seller to obtain the goods?

_____ a) Revolving

_____ b) Back-to-Back

_____ c) Transferable

_____ d) Red Clause

Question 11: Match the type of standby letter of credit with the application. Use G forguarantee and P for payment.

_____ a) In lieu of a bid bond

_____ b) In lieu of bank guarantees

_____ c) Salary disbursements

_____ d) Principal and/or interest on bonds payments

_____ e) Security for advance payments

Question 12: A standby letter of credit is different from a commercial letter of creditbecause a:

_____ a) commercial letter of credit requires the beneficiary to presentshipping documentation to draw against the letter of credit.

_____ b) standby letter of credit is always revocable.

_____ c) commercial letter of credit does not have an expiration date.

_____ d) standby letter of credit can be viewed as either an import letterof credit or an export letter of credit.

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ANSWER KEY

Question 10: A seller, who will have a letter of credit opened in his favor, does not havefunds to purchase the goods from his supplier and does not qualify for abank loan. What would be the least complicated letter of credit to beissued that would enable the seller to obtain the goods?

c) Transferable

Question 11: Match the type of standby letter of credit with the application. Use G forguarantee and P for payment.

G a) In lieu of a bid bond

G b) In lieu of bank guarantees

P c) Salary disbursements

P d) Principal and/or interest on bonds payments

G e) Security for advance payments

Question 12: A standby letter of credit is different from a commercial letter of creditbecause a:

a) commercial letter of credit requires the beneficiary to presentshipping documentation to draw against the letter of credit.

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Question 13: What option is available to a beneficiary who is in need of financing topay its supplier, but does not wish to issue another letter of credit or changea letter of credit already opened in its favor?

_____ a) Revolving

_____ b) Back-to-Back

_____ c) Transferable

_____ d) Assignment of Proceeds

Question 14: Select the one correct tenor for each settlement.

_____ a) Sight Payment

_____ b) Negotiation

_____ c) Deferred Payment

_____ d) Acceptance

1. Payment is made immediately to thebeneficiary when complying documentsare presented

2. Payment is made to the beneficiary at aspecified future date

3. Payment is made immediately to thebeneficiary, normally at a discount, uponpresentation of the complying documents

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ANSWER KEY

Question 13: What option is available to a beneficiary who is in need of financing topay its supplier, but does not wish to issue another letter of credit or changea letter of credit already opened in its favor?

d) Assignment of Proceeds

Question 14: Select the one correct tenor for each settlement.

_____ a) Sight Payment

_____ b) Negotiation

_____ c) Deferred Payment

_____ d) Acceptance

1. Payment is made immediately to thebeneficiary when complying documentsare presented

2. Payment is made to the beneficiary at aspecified future date

3. Payment is made immediately to thebeneficiary, normally at a discount, uponpresentation of the complying documents

1

3

2

2

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Question 15: Match each of the five customer needs to one of the three instruments thatwill best meet the need.

_____ a) A seller who is shipping to a buyer on open account may expect thebuyer to provide a bank assurance that payment will be made when due.

_____ b) A company may need to support a foreign subsidiary in its localborrowing needs. A foreign lending bank has indicated a willingnessto accommodate the subsidiary’s borrowing needs if such borrowingsare backed by a prime international bank.

_____ c) A company may be interested in bidding on a sale of goods to a certainbuyer. The buyer’s invitation to bid includes a stipulation that allbidders must post a bond or promise to establish financial responsibilityand to assure that, if awarded the bid, the bidder will enter into a firmcontract.

_____ d) A company may enter into a contract to supply services in which thebuyer requires the supplier to post a bond or ensure that, if the supplierfails to perform and execute the contract in accordance with all its termsand conditions, a monetary compensation will be made.

_____ e) In the course of a project, a buyer may be required to make progresspayments to the supplier. The buyer may require that the supplier obtaina bank guarantee that, in the event of nonperformance by the supplier,the buyer will be reimbursed for all of the progress payments.

_____ f) As part of a divorce settlement, one of the parties requires alimonypayments under a letter of credit by the other party who has moved toa distant country. The condition is that if the party receiving alimonymarries, the other party is no longer under obligation to continue thepayments. What is the appropriate letter of credit for this situation?

Instruments available: 1. Standby letter of credit, irrevocable, payment type 2. Standby letter of credit, irrevocable, guarantee type 3. Standby letter of credit, revocable, payment type

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ANSWER KEY

Question 15: Match each of the five customer needs to one of the three instruments thatwill best meet the need.

_____ a) A seller who is shipping to a buyer on open account may expect thebuyer to provide a bank assurance that payment will be made when due.

_____ b) A company may need to support a foreign subsidiary in its localborrowing needs. A foreign lending bank has indicated a willingnessto accommodate the subsidiary’s borrowing needs if such borrowingsare backed by a prime international bank.

_____ c) A company may be interested in bidding on a sale of goods to a certainbuyer. The buyer’s invitation to bid includes a stipulation that allbidders must post a bond or promise to establish financial responsibilityand to assure that, if awarded the bid, the bidder will enter into a firmcontract.

_____ d) A company may enter into a contract to supply services in which thebuyer requires the supplier to post a bond or ensure that, if the supplierfails to perform and execute the contract in accordance with all its termsand conditions, a monetary compensation will be made.

_____ e) In the course of a project, a buyer may be required to make progresspayments to the supplier. The buyer may require that the supplier obtaina bank guarantee that, in the event of nonperformance by the supplier,the buyer will be reimbursed for all of the progress payments.

_____ f) As part of a divorce settlement, one of the parties requires alimonypayments under a letter of credit by the other party who has moved toa distant country. The condition is that if the party receiving alimonymarries, the other party is no longer under obligation to continue thepayments. What is the appropriate letter of credit for this situation?

Instruments available:1. Standby letter of credit, irrevocable, payment type2. Standby letter of credit, irrevocable, guarantee type3. Standby letter of credit, revocable, payment type

1

1

3

2

2

2

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Question 16: A letter of credit may be viewed as an import or export letter of credit,depending on the perspective a given party has of the transaction. Matchthe following parties with how they would view the same letter of creditin a trade transaction.

_____ a) Issuing Bank 1) Import Letter of Credit

_____ b) Beneficiary 2) Export Letter of Credit

_____ c) Advising Bank

_____ d) Buyer

_____ e) Seller

_____ f) Applicant

_____ g) Paying Bank

_____ h) Confirming Bank

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ANSWER KEY

Question 16: A letter of credit may be viewed as an import or export letter of credit,depending on the perspective a given party has of the transaction. Matchthe following parties with how they would view the same letter of credit ina trade transaction.

_____ a) Issuing Bank 1) Import Letter of Credit

_____ b) Beneficiary 2) Export Letter of Credit

_____ c) Advising Bank

_____ d) Buyer

_____ e) Seller

_____ f) Applicant

_____ g) Paying Bank

_____ h) Confirming Bank

1

2

2

1

2

1

2

2

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FINANCIAL AND COMMERCIAL TRANSACTION DOCUMENTS

Many documents facilitate the exchange of goods and services.In this section you will learn about the different financial andcommercial documents necessary for different trade transactions.

Financial Documents

A financial document may be a check (cheque), draft (bill ofexchange), or promissory note. We describe them below.

Check

A check must be drawn on a bank and can be payable only at sight.

Draft / Bill of Exchange

Order to pay A draft or bill of exchange (the terms are used interchangeably) isa written order to pay a sum of money. A draft, the most commondocument involved in the payment of trade transactions, representsa commitment to pay for goods when cash terms are not used.

The seller (drawer), who is the beneficiary of the payment,generates the draft drawn on the party (drawee) who has agreed tomake the payment. The drawee (buyer) may be a person or businesswho owes money to the drawer (seller), or it may be the bank that isresponsible for making payment under a letter of credit.

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Sight andtime drafts

There are two types of drafts: “sight” and “time.”

n With a sight draft, the payment is made at “sight” or whenthe draft is presented.

n The time draft commits the buyer to release the funds aftera fixed period of time, such as thirty, sixty, or ninety days.For example, the buyer may want to purchase goods from theseller, but cannot pay the seller until the goods are resold.The time draft gives the buyer time to sell the goods andreceive the money needed to pay the seller. A time draftdrawn under a letter of credit is usually drawn on thenegotiating bank by an exporter, which originates a bankers’acceptance (see Unit 3).

Promissory Note

Promise ofpayment

A promissory note is the most frequently used borrowinginstrument in banking. By signing a note, the borroweracknowledges receipt of the money and commits to repay it, withor without interest, in a lump sum or in installments. A promissorynote has most of the same features as a draft or bill of exchange.The main difference is that it represents a direct promise ofpayment by the person who signs the note, rather than an orderto pay. A promissory note is an “I owe you,” whereas a draft is a“you owe me.”

Negotiableinstruments

Checks, bills of exchange, and promissory notes are the threemain types of negotiable instruments since they are often usedas payment devices in international trade. Promissory notes andaccepted bills contain an unconditional promise to pay a specifiedsum of money. That promise can be bought and sold by endorsingand handing over the piece of paper on which it is written.

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Commercial Documents

A commercial document may be an invoice, bill of lading,insurance document / policy, or other shipping document.

Commercial Invoice

Billingdocument

A commercial invoice is a billing document issued by the seller andaddressed to the buyer. It describes the goods or services, their price,and any other charges or relevant information about the transaction.

The commercial invoice does not give title to the goods. Because itis a billing document, precise terms must be used and it only can beamended by a separate debit or credit note.

Bill of Lading

Title document A bill of lading is a transportation or shipping document issued bythe transportation company when moving goods from the seller tothe buyer. The bill of lading provides:

n Receipt for the goods delivered to the carrier for shipment

n Contract of carriage of the goods from the place of receiptto the place of delivery listed in the bill of lading

n Evidence of title to the goods

The name of the bill of lading indicates the kind of transportation:

n Ocean or marine bill of lading for shipments over water

n Air waybill for air transportation

n Truck bill of lading for transportation by truck

n Rail bill of lading for shipments by rail

n Intermodal bill of lading when more than one type oftransportation is necessary

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Insurance Document / Policy

Coveragefor losses

The insurance document (policy) provides coverage for any lossesor damages to the merchandise incurred when in transit. Either theimporter or the exporter obtains coverage, depending on who hastitle to the goods during shipment.

The policy states all the risks that are covered and the length ofcoverage. The time period is usually from the date when the sellerdelivers the goods to the shipping agency until the estimated time ofarrival of the goods at the buyer’s warehouse.

Unless otherwise stated in the letter of credit, an insurance policyshould:

n Financially cover the risks mentioned in the letter of credit

n Not be dated after the shipment date, or have an inceptiondate (beginning of validity period) prior to shipment date

n Be denominated in the same currency as the letter of credit

n Cover at least 110% of the total cost of the goods fordelivery to warehouse

n Be in negotiable form signed and endorsed

n Be issued by an insurance company, underwriter or theiragents, and not by an insurance broker

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Other Documents

Depending on the needs of the buyer and the characteristics of themerchandise, one or more other documents may be required.

n A certificate of origin states where the goods weremanufactured or grown. It is usually issued by anofficial or an independent party such as a Chamber ofCommerce. The certificate serves as proof for the buyerto obtain fiscal credit or exchange benefits in the buyer’scountry because of special trade treaties between countries.

n A weight list indicates the gross and net weights perpackage or volume and the total gross and net weight ofthe overall cargo.

n A packing list, used by customs for inspection purposes,indicates the contents of each package being shipped andaccompanies the cargo. The packing and weight lists maybe combined to form a single document.

n An inspection certificate is required by importers formerchandise of great value and quality. For example, abuyer purchasing steel of a certain grade or quality mayrequest an inspection certificate indicating the grade ofsteel. A designated professional or company inspects themerchandise upon delivery to the shipping company orjust before shipment and issues the inspection certificate.

n A quality certificate, similar to the inspection certificate, isissued by an expert who verifies that the merchandise to beshipped agrees with the description shown on the transportdocument and the commercial invoice. The quality certificatecan replace the inspection certificate.

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Sometimes the quality certificate has to be approved bythe embassy of the buyer’s country. Possible scenariosrequiring embassy approval include:

• The importer has had a bad experience with thesupplier or other suppliers from that country

• The importer is new to the business and lacksexperience with offshore purchases

n An analysis certificate, used for mineral or chemicalpurchases, verifies the percentage of each component. Thisinformation determines the pricing and possible usage ofthe raw materials. Bulk shipments of perishable goods suchas crops and gases also require analysis certificates. Theanalysis certificate can replace the inspection certificate.

UNIT SUMMARY

In this section, we examined the two types of documents necessaryto conduct trade transactions: financial and commercial. Thesedocuments include:

n Draft (bill of exchange) A written order to pay a sumof money

n Promissory note Signed commitment to repay a sumof money

n Commercial invoice Billing document issued by the sellerto the buyer

n Bill of lading Shipping document issued by thetransportation company when moving goods. It providesevidence of title to goods.

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n Insurance document Policy to cover losses or damages togoods when in transit. It is obtained by the party that has titleto the goods during shipping.

Additional documents may be required depending on the needsof the buyer and the characteristics of the merchandise.

To check your understanding of trade documents, please complete Progress Check 2.3and check your answers with the Answer Key. If you answer any questions incorrectly,please reread the corresponding text to clarify your understanding. When you havecompleted the Progress Check, continue with Unit 3: Trade Finance.

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Question 1: The document that transfers title is the:

_____ a) commercial invoice.

_____ b) bill of lading.

_____ c) draft.

_____ d) certificate of origin.

Question 2: Which document covers the risks that may affect the merchandise fromthe time it is delivered by the seller until it is received by the buyer?

_____ a) Insurance document

_____ b) Analysis certificate

_____ c) Commercial invoice

_____ d) Quality certificate

Question 3: Which document is provided by the seller to the buyer and givesa description and cost of goods and/or services?

_____ a) Analysis certificate_____ b) Inspection certificate_____ c) Weight list_____ d) Commercial invoice

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ANSWER KEY

Question 1: The document that transfers title is the:

b) bill of lading.

Question 2: Which document covers the risks that may affect the merchandise fromthe time it is delivered by the seller until it is received by the buyer?

a) Insurance document

Question 3: Which document is provided by the seller to the buyer and gives adescription and cost of goods and/or services?

d) Commercial invoice

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Question 4: A document that demands payment when it is presented is a:


_____ b) sight draft.

_____ c) time draft.

_____ d) promissory note.

Question 5: Merchandise imports that are priced according to a quality criteria mayrequire a(n):

_____ a) certificate of origin.

_____ b) shipping guaranty.

_____ c) letter of indemnity.

_____ d) inspection certificate.

Question 6: Which of the following documents are negotiable instruments?

_____ a) Promissory Note

_____ b) Commercial Invoice

_____ c) Bill of Lading

_____ d) Bill of Exchange

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ANSWER KEY

Question 4: A document that demands payment when it is presented is a:

b) sight draft.

Question 5: Merchandise imports that are priced according to a quality criteria mayrequire a(n):

d) inspection certificate.

Question 6: Which of the following documents are negotiable instruments?

a) Promissory Note

c) `Bill of Lading

d) Bill of Exchange

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Question 7: Place an F in front of the names of financial documents and a C in frontof the names of commercial documents.

_____ Bill of Exchange

_____ Bill of Lading

_____ Promissory Note

_____ Commercial Invoice

_____ Certificate of Origin

_____ Weight List

Question 8: A document that represents the buyer’s commitment to pay is a:


_____ b) sight draft.

_____ c) time draft.

_____ d) promissory note.

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ANSWER KEY

Question 7: Place an F in front of the names of financial documents and a C in frontof the names of commercial documents.

F Bill of Exchange

C Bill of Lading

F Promissory Note

C Commercial Invoice

C Certificate of Origin

C Weight List

Question 8: A document that represents the buyer’s commitment to pay is a:

d) promissory note.

Unit 3

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UNIT 3: TRADE FINANCE

INTRODUCTION

All trade transactions require some form of financing. If the seller allows the buyer time topay for purchased goods, the seller must borrow money or finance that period throughavailable cash. Conversely, if the seller requires cash on delivery, the buyer must cover theperiod between payment for the goods and the conversion of the goods into cash through asubsequent sale. In this unit, we examine the many factors that banks must consider inextending credit to customers (buyers and sellers). We then define the typesof transactions which may require trade financing as well as the credit instruments thathave been developed to meet these needs. From the perspective of a customer requiringpre- or export financing, we examine the structure and parties involved in exportfinancing. You will see how trade financing is provided by banks acting independently,with government support, or in cooperation with other banks.

UNIT OBJECTIVES


n Understand the process of extending credit to customers

n Identify trade financing options for trade transactions

n Understand two trade financing products: bankers’ acceptanceand forfaiting

n Recognize funding structures and mechanisms used by exportcredit agencies

n Understand how correspondent banks facilitate international trade

n Recognize three trade products that are common in internationalcorrespondent banking relationships

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EXTENSION OF CREDIT

The decision to extend credit to a customer is based on past experienceand present conditions. While it is not a precise science, the creditdecision does require consideration of specific issues. The goals ofextending credit are to service the needs of the customer and to earna profit for the lending bank. In this section, we examine the processof extending credit while achieving both goals.

Establishing Creditworthiness

Risk thatborrower maynot repay

Whenever a bank extends credit, there is always a risk that theborrower may not repay the loan. For each credit request, the bankmust gather all of the facts, analyze them, and make a decision aboutthe creditworthiness of the customer.

The process of extending credit begins with the bank asking somebasic questions:

1. How much money does the customer want?

2. For what purpose is the money going to be used?

3. For how long does the customer need to borrowthe money?

4. How does the customer plan to repay the money?

5. Does the customer’s business generate sufficientcash for repayment?

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In addition, the customer must provide specific informationabout its financial strength and reputation. The bank analyzes thecustomer’s financial statements in order to assess capacity andcapital. The financial statements include the income statement,balance sheet, and cash flow report. These statements summarizethe financial strength of an individual or company on any date andfor any period of time. They should be prepared and signed byindependent auditors.

For more information on statement analysis, you can order theself-instruction workbook, Financial Statement Analysis, through theTraining Coordinator in your country or the training area responsiblefor your region.

Identifying Risks

Besides evaluating the customer’s creditworthiness, the bank alsomust consider the risks of lending in other countries. Country riskincludes political (sovereign) and cross-border (transfer andconvertibility) risk.

Political(sovereign) risk

The political and economic environment of the borrower’scountry must be determined before credit is extended. Forexample, a country may experience civil wars, riots, orrevolutions that can affect world trade and the borrower’sability to repay his/her obligations.

Convertibilityrisk

In international lending, one of the parties has a currencyconversion exposure. US commercial banks usually extend loansin US dollars to foreign customers and want to be repaid in USdollars. When a borrower sells goods in a foreign country,payment will be in the currency of that country. Convertibilityrisk may occur if the central bank of, or the foreign exchangemarket in, the borrower’s country does not have the US dollarsavailable to sell to the borrower to allow repayment of the loan.

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Transfer risk Governments may change laws, regulations, or procedures whichalso may affect a borrower’s ability to repay loans. The borrowerin the country may not be allowed to transfer funds in the foreigncurrency of payment to the place of payment. As a result, the bankmust be knowledgeable about the situation in the borrower’scountry before approving an extension of credit.

We discuss risk in greater detail in Unit 4.

Setting Interest Rates

Interest ratereflects degreeof risk

As compensation for assuming risk, the bank charges a certaininterest rate for the use of its funds. The interest rate representsa percentage that the bank charges the customer for using theborrowed funds for a predetermined time. The amount of interestreflects and compensates for the degree of risk assumed by the bank.If the risk is higher, or the term of the loan longer, then the interestrate is higher.

Fixed / floatinginterest rate

A fixed interest rate does not change during the life of the loan. Afloating interest rate is reset periodically, depending on the existingmarket rate on the reset date. Loans may be funded with domesticdollars or Eurodollars. Eurodollars are US dollars deposited in abank outside the US such as a foreign bank, an overseas bank of aUS bank, or an International Banking Facility (IBF) (coveredunder “Use of Offshore Vehicles” later in this unit).

Prime rate Each bank sets its own prime rate for domestically-funded loans.The prime rate is a floating rate that is the most favorable interestrate charged by a commercial bank on short-term loans to its mostcreditworthy customers. If a borrower is not a most creditworthycustomer, the bank will quote an interest rate of prime plus a spread.Each bank’s prime rate is set at a level that covers the bank’s costof funds, its operating expense, and includes a margin of profit.Citibank calls the prime rate its “base rate.”

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LIBOR When loans are funded with Eurodollars, the bank borrows theEurodollars, pays the London Interbank Offered Rate (LIBOR), andlends these dollars to its customer. LIBOR is also a floating rate andrepresents the interest cost to the bank to obtain funds in this market.These loans are quoted as “LIBOR + x percent p.a.” The “x percentp.a.,” called the “spread,” represents the bank’s earnings.

The Eurodollars are time deposits and, therefore, LIBOR is quotedas a fixed rate based on tenor (30, 60, 90, 180, and 360 days, andbeyond one year). For a loan with a maturity of over a year, the bankmay take a Eurodollar deposit for six months at LIBOR and reprice theloan for successive six month increments. The borrower’s interest rateis fixed for each six month period and may change each time thedeposit is renewed.

Notice the difference in earnings between these two kinds of funding.The prime rate includes the cost of funds to the bank, plus an amountto cover the bank’s overhead, plus an amount to provide the bank witha profit. Since LIBOR only accounts for the cost of funds, the bankmust cover its overhead, be compensated for the credit risk, and earn aprofit from the increment charged over LIBOR (i.e. spread).

Establishing Credit Terms

In addition to setting the interest rate, the decision to extend creditalso involves establishing the terms of the credit. Different types ofloans have been developed for customers that cannot qualify forcredit based on their financial strength. Each customer’s financialsituation is unique, and the bank tries to find the best solution to meetthe customer’s needs.

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Secured loans When the bank makes a secured loan, it requires possession of,or title to, some outside value in addition to the signing of a debtinstrument. This collateral provides additional protection for thebank. Sometimes the provision of collateral results in the bank’swillingness to charge a lower interest rate. Other times, the bankwill lend only if collateral is pledged. (Note that an unsecured loanis granted on the financial strength and reputation of the borrower.The debt obligations are not backed by pledged collateral or asecurity agreement. A security agreement is a document whichlinks the collateral to a loan or credit facility.)

Guaranteedloans

Sometimes, a borrower may not qualify for a loan based on itsown financial strength or have collateral available to secure the loan.In this situation, another individual, bank, or company can guaranteerepayment of the loan to the bank. This is called a guaranteed loan.

The guarantor is the third party that assumes responsibility if theoriginal borrower fails to repay the loan. The bank makes the creditdecision based on the guarantor’s creditworthiness. In internationaltrade, the country risk of the guarantor also must be considered.When the guarantor is from the same country as the borrower, thesame risks apply. If the guarantor is from a different country than theborrower, the bank makes its decision based on the country risk of theguarantor.

Determining the Type of Financing

The nature of the transaction determines which type of financingshould be used. The various types of financing available for differentcredit needs include short and medium term loans, lines of credit, andsyndications.

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Short Term Loan

Loan up toone year

A short term loan is a loan with a maturity of up to one year. Theprincipal and interest are paid at maturity date and this is evidencedby a promissory note. As mentioned in Unit 2, a promissory note isa legal contract that formally recognizes the borrower’s obligation torepay the lender the loan amount, with interest, over a certain periodof time or by a stated date.

When the borrower is from a foreign country, the promissory notemust be enforceable in the United States courts and also, if possible,in the court of the borrower’s country.

Medium Term Loan

Maturity greaterthan one year

A medium term loan is a loan with a maturity greater than oneyear and less than five years. It is payable in installments and isevidenced by a credit agreement and a promissory note. If thebank implements a schedule of single or multiple disbursements(drawdowns) to the borrower, it should include the schedule ofrepayments (installments) by the borrower.

Line of Credit

Short-termborrowingson demand

A line of credit is an agreement with a bank for short-termborrowings on demand. It is the maximum amount a bank is willingto lend to a particular customer over a future period. Customers usea line of credit when they have a series of transactions to be financedover a period of time. In some cases, establishing a line of credit ismore appropriate than approving a series of one-time loans.

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Syndication

Loan made byseveral lenders

If a single bank is unwilling or unable to fund a single loan, it mayinvite several other banks to extend the loan jointly in order to spreadthe risks among the banks. A syndication is a loan made by severalbanks or lenders that form an association to assume the responsibilityand share the risks of the loan.

In a syndication, a lead bank manages the transaction, and all otherbanks in the consortium are disclosed to each other and to thecustomer (borrower). The customer must assess the counterpartyrisk of each member of the consortium. If one bank fails to provideits portion of the loan, the customer (borrower), not the lead bank,bears the risk.

A smaller bank often joins a syndication to diversify its loan portfolioand to gain recognition as an international bank — a status whichmay generate new business opportunities, but which may also createrisks that it may not be prepared to manage.

Booking Transactions

Offshorevehicle:InternationalBanking Facility(IBF)

An offshore vehicle, such as Citibank NY International BankingFacility (IBF), is used for booking international trade transactions.It is not a separate banking entity, but a separate group of accountsor bookkeeping systems set up by a US bank or a US branch of aforeign bank to record international banking transactions. AlthoughIBFs are physically located in the US, they are not subject to eitherreserve requirements or assessments for deposit insurance. Unlikeother US banking facilities, they may offer deposits denominatedin currencies other than the US dollar. They also can receivedeposits from, and make loans to, nonresidents of the US or otherIBFs. The IBF is the offshore vehicle most frequently used forbooking trade loans.

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Managing the Credit

Monitoringthe customer

The bank must remain in contact with the customer (borrower)during the disbursement of a credit to ensure that the customerreceives the funds as directed on the loan agreement and that thefunds are being used for the purpose stated in the loan agreement.

The bank should closely watch the customer’s financial health.Delayed payments, information from trade sources of other latepayments, or requests for additional short-term financing mayindicate that the borrower is having difficulties. It is important torecognize problems and address them as soon as possible.

Now that you have a feel for the bank’s credit process, we willlook at the types of trade transactions that may require an extensionof credit.

PURPOSES FOR TRADE FINANCING

Trade financing is the process of making available extensions ofcredit or other financing to meet the needs of both the importer(buyer) and the exporter (seller).

Parties to an international transaction usually buy and sell on eithera cash or credit (deferred payment) basis. Even cash transactions,when payment is made on receipt of the goods, may require:

1) A term of credit from the completion of manufacturing /production to the receipt of payment

– or –

2) Financing to provide the necessary capital to manufactureand/or assemble the goods to be exported

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Product /Service—limited suppliers

If the exporter has a product / service in high demand due to alimited number of suppliers, it is most likely that the exporter willwant to be paid in cash at the time of sale. In this case, either theimporter has sufficient funds to pay the exporter based on the termsand conditions of the sale or the importer cannot pay within thetimeframe designated by the exporter. If the importer cannot payaccording to the terms and conditions of the sale, the exporter hasthe following options:

n Consider other importers able to meet the exporter’spayment terms

n Insist that the importer obtain financing from a local orinternational bank to make the payment

n Obtain financing for the buyer either through the exporter’sown bank or through government programs such as theexport credit agency of the exporter’s country. (This iscalled buyer credit and is covered in more detail in thethird section of this unit.)

n Wait until the importer is able to sell the imported goodsin order to generate the cash for payment

n Provide credit to the importer by offering deferred paymentterms (This is called supplier credit and is covered in moredetail in the third section of this unit.)

Depending on the option, the exporter may want to obtain thenecessary insurance coverage for those risks which prevent theimporter from:

n Generating the funds

n Converting its local currency to the exporter’s countrycurrency

n Transferring the currency to the exporter’s country

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If the exporter needs financing to produce the products, the exportermay obtain it from a local or international bank or throughgovernment programs offered by its own country.

Product /Service —many suppliers

If the exporter (seller) has a commodity product / service that isoffered by many suppliers, the exporter should be more willing toprovide credit terms to the importer (buyer). If the importer canonly pay at a future date, because the goods must be sold in order togenerate the cash payment, the exporter can provide supplier creditfinancing. In this case, the exporter has the following two options:

n Receive payment by selling its receivable due from theimporter (goods or services capable of being convertedinto cash, now or at a future date) to a bank

n Hold it as a receivable until payment date

Trade finance serves a variety of purposes such as pre-exportfinancing, export financing, import financing, and inventoryfinancing. Next, we define each of these transactions.

Pre-Export Financing

Acquisition andpreparation ofgoods for export

In pre-export financing, the exporter (seller) has a firm contract ofsale but needs financing to acquire and prepare the goods forshipment. Manufactured or processed goods, as well as readilymarketable staples (e.g. wheat, sugar, corn, coffee, copper, silver),may be financed.

Lack of working capital financing is one of the greatest obstaclesan exporter may face and often can prevent companies from fillingexport orders. For instance, a manufacturer lacks the resources toobtain financing domestically for an overseas sale. The companyhas already reached the borrowing limit on its domestic line of credit,and its domestic bank is unwilling to lend against a foreign contractand the foreign receivable it will generate. If unable to obtain thenecessary pre-export working capital, the exporter will risk losing thesale to its overseas competitors.

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Citibank in Latin America offers a flexible financing approachcalled pre-payment of exports, a unique product of Brazil.

Pre-paymentof exports

Pre-payment of exports allows an exporter to obtain financingfrom foreign banks or directly from the importer. Depending onthe exporter’s track record or current export sales contract, theexporter may obtain pre-payment of exports from Citibank.

Once Citibank agrees with the exporter on the financing terms(e.g., tenor, amount, pricing, importer(s), documentation), Citibankadvances the funds by remitting a US dollar payment order from anyoffshore vehicle (Citibank NY IBF, Citibank Nassau) to the exporter.

The exporter closes a spot export foreign exchange contract withCitibank (or some other local bank as agreed in the initialnegotiations). As a result, the exporter receives the local currencyequivalent to be used for the purchase, manufacturing, and shippingof the goods.

Once the exporter ships the goods in accordance with the schedulepreviously negotiated with Citibank, the exporter presents theshipping documentation to the bank for review and collection.

Upon acceptance, the bank delivers the documentation to the importerand, in return, the importer pays Citibank NY. On the other hand, theexporter pays interest to Citibank NY (or any other vehicle asappropriate) on the advance it received based on the negotiatedpricing and conditions (end-of-period, quarterly, semi-annually, uponeach shipment, or as otherwise negotiated).

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Export Financing

Interval betweenshipment andreceipt ofpayment

In export financing, the exporter (seller) needs financing for theperiod between shipment of the goods and receipt of payment fromthe importer (buyer). The exporter can ship under an open account,documents against acceptance or documents against payment basis,or letter of credit. In this instance, the exporter (seller) is providingsupplier credit to the importer (buyer).

Import Financing

Financingto pay forpurchasedgoods

In import financing, the importer (buyer) who is purchasing goodsunder a sight letter of credit or under other payment terms (openaccount, term letter of credit) may need financing to meet therequired payment.

Inventory (Warehouse) Financing

Inventory andsale of readilymarketablestaples

In inventory or warehouse financing, an exporter (seller) needsfinancing to hold readily marketable staples in storage and completethe sale of these staples to a buyer within the seller’s country oroverseas. In reality, inventory or warehouse financing is a type ofsecured lending because the goods serve as collateral for the loan.

The exporter (seller) must pledge to the bank a warehouse receiptcovering the goods, issued by an independent third party. Thewarehouse receipt is a title document which states that a warehousecompany is holding a certain quantity of a specific commodityand that the company will continue to hold these goods until thewarehouse receipt is presented. At such time, the merchandise isreturned in exchange for the warehouse receipt.

Only readily marketable staples or commodities (such as oil) qualifyfor storage financing on an eligible banker’s acceptance basis(discussed under “Commercial Financing” in the next section).

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Summary

A decision to extend credit requires the bank to establish thecreditworthiness of the customer, identify the risks, set the interestrate, establish credit terms, select the type of financing, book thetransaction, and manage the credit.

Trade financing may be required by an importer when the exporterhas a product or service that is in high demand. In this case, theimporter may have to pay cash at the time of the sale. On the otherhand, if there are many suppliers of a product or service, the exportermay have to extend credit to the importer in order to attract thecustomer’s business. In this case, the exporter may need financinguntil the receivable is paid.

Actually, there are four potential elements of a trade transactionthat may require trade financing — pre-export, export, import,and inventory.

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Question 1: When a bank extends credit to finance a trade transaction, the spreadcharged by the bank reflects (select two):

_____ a) LIBOR.

_____ b) the creditworthiness of the borrower.

_____ c) the degree of risk assumed by the bank.

_____ d) the borrower’s line of credit.

Question 2: The prime rate is:

_____ a) a fixed interest rate charged by a bank to its “prime” customers.

_____ b) a floating interest rate that a bank pays to borrow Eurodollars.

_____ c) an interest rate that only accounts for the bank’s cost of funds.

_____ d) the best rate charged by a bank on short-term loans to customerswith the highest credit ratings.

Question 3: Select two types of loans that may be given to customers that cannotqualify for credit based on creditworthiness.

_____ a) Loans that require possession of, or a title to, something of value

_____ b) Obligations that rely on the sound financial health and reputationof the borrower

_____ c) Loans backed by another bank

_____ d) Loans with tenors of less than one year

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ANSWER KEY

Question 1: When the bank extends credit to finance a trade transaction, the spreadcharged by the bank reflects (select two):

b) the creditworthiness of the borrower.

c) the degree of risk assumed by the bank.

Question 2: The prime rate is:

d) the best rate charged by a bank on short-term loans to customerswith the highest credit ratings.

Question 3: Select two types of loans that may be given to customers that cannotqualify for credit based on creditworthiness.

a) Loans that require possession of, or a title to, something of value

c) Loans backed by another bank

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Question 4: LIBOR is a rate which banks may use to:

_____ a) establish the acceptance discount rate.

_____ b) quote a floating-rate loan to a customer.

_____ c) set their fixed lending rates.

_____ d) determine interest charges for unsecured loans.

Question 5: “Import financing” means that the:

_____ a) seller needs financing to acquire and prepare goods for shipment.

_____ b) seller needs financing for the period between shipment of thegoods and receipt of payment from the buyer.

_____ c) buyer needs financing to meet the required payment for thepurchase of the imported goods.

_____ d) buyer needs financing to store purchased goods prior to their sale.

Question 6: When a buyer requires financing to meet the required payment undera sight letter of credit, the transaction may be described as:

_____ a) pre-export financing.

_____ b) warehouse financing.

_____ c) export financing.

_____ d) import financing.

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ANSWER KEY

Question 4: LIBOR is a rate which banks may use to:

b) quote a floating-rate loan to a customer.

Question 5: “Import financing” means that the:

c) buyer needs financing to meet the required payment for the purchaseof the imported goods.

Question 6: When a buyer requires financing to meet the required payment undera sight letter of credit, the transaction may be described as:

d) import financing.

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Question 7: Exporters with firm sales contracts may need pre-export financingto provide:

_____ a) adequate working capital to prepare goods for shipment.

_____ b) a hedge against foreign exchange risk.

_____ c) warehouse facilities prior to delivering the goods.

_____ d) an extension of credit to the importer.

Question 8: Export financing:

_____ a) is supplier credit extended by the importer to the exporter.

_____ b) improves the exporter’s cash flow until payment is received fromthe importer for goods that have been shipped.

_____ c) is obtained from the bank by the importer to fulfill the terms of adocumentary collection.

_____ d) can only be obtained by the exporter to finance an open accounttransaction.

Question 9: Inventory financing may be needed by the:

_____ a) importer to increase its inventory.

_____ b) exporter to purchase inventory for the production of goods.

_____ c) importer who uses the goods to secure the loan.

_____ d) exporter to store goods until completion of the sale.

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ANSWER KEY

Question 7: Exporters with firm sales contracts may need pre-export financingto provide:

a) adequate working capital to prepare goods for shipment.

Question 8: Export financing:

b) improves the exporter’s cash flow until payment is receivedfrom the importer for goods that have been shipped.

Question 9: Inventory financing may be needed by the:

d) exporter to store goods until completion of the sale.

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Question 10: Transatlantic Imports is a Citibank customer and wants to pay for importedgoods 120 days from the shipment date. However, the exporter demandspayment at sight. What type of financing should Citibank provide?

_____ a) Import financing to the importer

_____ b) Pre-export financing to the importer

_____ c) Import financing to the exporter

_____ d) Pre-export financing to the exporter

Question 11: ABC Company, located in Korea, is a reliable producer and exporter ofsilicon chips. Due to company finances, they are having difficulty in meetingtheir commitment to provide Hi-Tec, Inc., a US importer, with 600,000 chipswithin the next two months. What type of financing wouldbe the best solution for this situation?

_____ a) Pre-export Financing

_____ b) Import Financing

_____ c) Export Financing

_____ d) Inventory Financing

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ANSWER KEY

Question 10: Transatlantic Imports is a Citibank customer and wants to pay for importedgoods 120 days from the shipment date. However, the exporter demandspayment at sight. What type of financing should Citibank provide?

a) Import financing to the importer

Question 11: ABC Company, located in Korea, is a reliable producer and exporter ofsilicon chips. Due to company finances, they are having difficulty in meetingtheir commitment to provide Hi-Tec, Inc., a US importer, with 600,000 chipswithin the next two months. What type of financing wouldbe the best solution for this situation?

a) Pre-export Financing

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TYPES OF EXPORT FINANCING

We have seen that trade financing may serve a variety of purposes. Inthis section, we focus on export financing and examine several wayssuch financing may be structured. Remember, export financing fromthe exporter’s perspective is when the exporter (seller) needsfinancing between shipment of goods and receipt of payment; fromthe importer’s perspective, the importer (buyer) needs deferredpayment terms for the goods or services that an exporter (seller)is providing. Export financing alternatives include:

n Commercial financing

n Export Credit Agency (ECA)-supported financing

n Private insurance-supported financing

Commercial Financing

Small-scaleexport contracts

Commercial financing in export financing usually involves letters ofcredit, bankers’ acceptances, and forfaiting. It is most appropriatefor financing small-scale export contracts with maturities usuallyunder one year. We have already covered letters of credit, so wewill now describe the use of bankers’ acceptances and forfaitingfor export financing.

Recall, from Unit 2, that drafts may be drawn payable at “sight”or at a predetermined future point in time (normally anywhere from30 to 180 days after “sight”).

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Time Draft Suppose that an importer (buyer) requires a period of credit whichthe exporter (seller) is prepared to grant. This gives the importertime to sell some or all of the goods before having to pay. Theexporter draws a time draft or bill of exchange on the importerwith a usance period (a length of time allowed for payment). Theimporter then “accepts” the bill of exchange and returns it to theexporter.

Acceptance An acceptance, therefore, is a time draft (bill of exchange) thatrepresents a promise made by the buyer (drawee) to honor theinstrument at maturity date. The buyer writes “accepted” overhis/her signature. The act of acceptance is without recourse as it isa commitment to pay at maturity. The party is accepting or agreeingunconditionally to pay the time draft at a particular time and place.

Tradeacceptance

In a trade acceptance, the exporter (seller) of the goods draws atime draft on the importer (buyer). It is accepted by the importer forpayment at a specified future date. The payment of the time draft isnot assured by the bank.

The seller may require a guarantee or an “aval” if a bank is tocover the commercial risk. (This concept is discussed further inthe “Forfaiting” section — see page 3-29).

For instance, in the case of documentary collections, where theexporter (seller) provides 180-day terms, the exporter draws a180-day draft on the importer (buyer), payable to either the seller orthe collecting bank that represents the seller. A trade acceptance iscreated when the importer (buyer) accepts the 180-day draft whichgives the buyer possession of the documents. The acceptor is thebuyer who has the obligation to pay.

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Banker’s Acceptance

Bank’sobligationto pay

A banker’s acceptance is a short-term credit instrument that isoften used in international trade. It is a time draft drawn by thecustomer / obligor (e.g. an applicant of a letter of credit) on a bank“and accepted by the bank” and is called the accepted draft. Thisrepresents the bank’s obligation to pay another party (e.g. thebeneficiary of a letter of credit) a stated amount on a predeterminedfuture date. The creation of a banker’s acceptance is an extension ofcredit by the bank to its obligor. The bank is responsible for payingthe face value of the acceptance at maturity even if the customergoes out of business.

A banker’s acceptance is most commonly used in conjunction withletters of credit and is a mechanism for financing short-term trade.

As with any extension of credit, the bank makes its decision basedon the customer’s credit history, current financial condition, andrisks involved. Since there is an active secondary market for bankers’acceptances, the bank may subsequently sell the acceptances to aninvestor in the secondary market.

Application of Bankers’ Acceptances

The following example illustrates the use of a bankers’ acceptance forexport financing.

Example n A US exporter (seller) agrees to the terms of a sale ofgoods to a foreign buyer which require that the importer(buyer) open a letter of credit. The letter of credit is openedby the foreign bank and is advised through a US bank.

n The US exporter (seller), the beneficiary of the letter of credit,has offered 90-day financing to the importer (buyer). Theseller presents documents to the paying bank and draws adraft that matures in 90 days. The value of the draft equals thecost of the goods which includes the exporter’s estimate of aninterest rate for the 90-day period.

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n The paying bank accepts the draft and the draft becomesa banker’s acceptance. The exporter (seller) owns thebanker’s acceptance.

n The exporter (seller) may hold the banker’s acceptanceand present it to the bank at maturity for payment, but, morelikely, it will discount it with the bank.

Acceptances are popular as short-term investments, and banksnormally keep them on their balance sheets (an active secondarymarket exists, composed of investors and banks).

Use of the banker’s acceptance enables the exporter in the US totake advantage of the generally lower cost of US financing; the costsavings may be reflected in a lower purchase price for the buyer.

Pricing

Pricecomponents

Acceptance financing contains two cost elements:

1. Acceptance Commission Rate (spread)

When accepting a draft, a bank charges an acceptancecommission to compensate for its assumption of the credit riskand to cover the administrative costs of the transaction. Theamount charged depends on the bank’s assessment ofthe credit risk involved.

2. Acceptance Discount Rate (cost of funds)

When the bank discounts an acceptance, remitting funds to theseller (drawer of the draft), it charges interest in the form of adiscount from the face value. This rate is the bank’s charge forthe cost of funds. The specific rate is determined by conditionspresent in the money markets at the time of discount.

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All-in rates Acceptances are quoted on a discount basis, frequently as “all-inrates” that mask the actual acceptance commission rate. (The all-inrate is the acceptance commission rate plus the discount rate.)

Eligible and Ineligible Banker’s Acceptance

A banker’s acceptance, accepted by a bank in the US, may be eithereligible or ineligible for discount or purchase by a Federal ReserveBank. Although the Fed actually stopped discounting acceptancesin the late 1970s, the eligibility requirements remain important. Theaccepting bank does not have to maintain reserves against eligiblebankers’ acceptances, even though they are kept on the bank’sbalance sheet, and there is an active secondary market.

Eligiblebanker’sacceptance

To be “eligible,” the tenor of a banker’s acceptance cannot exceedsix months (180 days). The acceptance must be self-liquidatingand there can be no other financing for the same transaction. Themerchandise must be in the “channels of trade,” which means thatthe goods are being manufactured, packaged, shipped, received,stored, or resold. An eligible banker’s acceptance must come fromone of three transactions:

n Import or export of goods between the US andforeign countries and between foreign countries

n Domestic shipment of goods within the US

n Storage of marketable commodities in the US and/or in foreign countries

Ineligiblebanker’sacceptance

If a banker’s acceptance has not been created from one of theeligible transactions, or if it involves a draft with a tenor ofmore than six months, it is considered an ineligible banker’sacceptance. By accepting an ineligible draft, the bank is simplyextending a loan to its customer and must post reserves against itsince the acceptance is not backed by the Federal bank. When thebank’s prime rate is high, the bank may use an ineligible banker’sacceptance as a way to make a loan at a lower rate than thebank’s prime rate.

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Both types of bankers’ acceptances are permissible and both arefreely negotiable. Because the accepting bank is not required topost reserves against the eligible banker’s acceptance, it is moreappealing to banks (they can be more freely discounted in themarketplace) and less expensive to the borrower (e.g. beneficiary).

When pre-export expenses related to manufacturing are financed,bankers’ acceptances cannot be used to acquire raw materials andcover manufacturing costs.

Risks

For the creation of the eligible banker’s acceptance transaction, thereare three major sources of risk for the bank:

n Legal and Regulatory Risks

n When the banker’s acceptance is initiated, the bankmust comply with US regulations; otherwise, the bankmay be exposed to fines, civil and criminal penalties,and negative publicity.

n Credit Risk

n Operational Risks

When payment is made, the documents must be complete andproperly authenticated. When documents do not conform, thebank is exposed to litigation and financial loss.

When the bank discounts the acceptance, the bank may beexposed to financial loss if it uses the wrong rate or wrongtime period.

In addition to letters of credit and bankers’ acceptances, there isa third option for the pure commercial financing of internationaltrade. Let’s now examine forfaiting.

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Forfaiting

Rightsexchangedfor discountedcash payment

“Forfaiting” is a term that comes from the French word à forfait,meaning to surrender or relinquish the rights to something. Theexporter (seller) surrenders the right to any claim for payment onthe goods delivered to an importer in return for a discounted cashpayment for these same goods from a forfaiting institution.

Primary market Forfaiting, therefore, is the purchase of debt instruments due tomature in the future that originated from the provision of goods andservices, primarily export transactions. Their purchase is withoutrecourse to any previous holder of the instruments.

Forfaiting allows an exporter to offer extended terms to an importer(buyer). The exporter receives a bill of exchange or promissory notefor the goods from the importer and then sells the note to a financialagent (forfaiter or forfaiting company).

A bank, such as Citibank, may be the financial agent whichpurchases from the exporter (seller) and may decide to:

n Hold the bill of exchange or promissory note, takingthe importer’s credit risk (may eliminate the need forbank guarantee) and the importer’s country risk

n Resell through the forfait market

SecondaryMarket

As soon as a forfaiter has purchased forfaited assets, it has madean investment. The forfaiter may not wish to hold this asset untilits maturity and may, therefore, resell the note to an investor whothen becomes the forfaiter. Investors who buy / sell forfaited assetsin this way operate in the “secondary market.”

Guarantor Because the forfaiter is purchasing a debt instrument withoutrecourse to the seller, the forfaiter is bearing all the risks of non-payment by the importer. If the importer’s financial strength isinadequate and the importer does not have sufficient collateral topledge, the forfaiter will require that another corporation or bank(guarantor) be chosen to guarantee payment to the forfaiter in the

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event of the importer’s nonpayment.

Before its sale in the primary and/or secondary markets, thepromissory note must be issued in an unconditional and negotiableform that completely separates debt repayment from any contractdisputes between the buyer and the seller regarding performanceor quality of the goods sold.

Forfaitingapplications

Forfaiting can be used for short-term or medium-term credit.The maturities range from six months to ten years, with periodicinstallment payments for the goods and services sold usuallyrequired by the forfaiters. While it can be arranged for smallertransactions, forfaiting is usually done for transactions of morethan one million dollars.

In theory, the paper may be denominated in any currency. However,currencies which are not freely convertible, and are restricted bycontrol regulations, are not attractive to investors.

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A step-by-step example of a forfait transaction is illustrated inFigure 3.1, below.

Figure 3.1: Forfaiting flow

Transactionsteps

The steps are as follows:

1. The exporter and importer agree on the deferred paymentterms and the interest rate to apply on the settlement of acommercial contract.

2. The importer obtains a commitment from a bank to giveits “aval” (unconditional and irrevocable guarantee) on thenegotiable document (accepted draft / bill of exchange /promissory note) which represents the obligation of theimporter.

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3. The importer informs the exporter of the name of the bankwhich agreed to give its aval to the importer’s indebtedness.

4. The exporter proposes business to a forfaiter, and obtainsan offer from the forfaiter to buy the draft(s) or promissorynote(s) at the quoted discount rate based on yield to maturity(YTM). Offers are generally firm and incorporate an optionperiod (for example, 30 days) to allow the exporter to fullyreceive the documents to be discounted. Thus, the offercontains:

n A discount rate based on the YTM

n The option fee (for example, 0.125% flat)

n The commitment fee (for example, 0.10% permonth) for the time from expiration of theoption period until delivery of the documents

5. The exporter confirms with the forfaiter his/her acceptanceof the offer and pays the option fee.

6. The exporter ships the goods.

7. The exporter draws a draft(s) on the importer and requestsits acceptance, together with the bank aval. Alternatively,the exporter requests from the importer the promissory notesin favor of the exporter, with the same bank’s aval.

8. As the exporter awaits the guaranteeing bank’s avalization,as of the expiration of the option period, the exporter startspaying the commitment fee to the forfaiter until delivery of thedocuments.

9. The exporter delivers to the forfaiter the avalized billsof exchange (accepted drafts) or promissory notes.

10. The forfaiter discounts them and pays the exporter.

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11. The bills of exchange or promissory notes are furtherdiscounted and traded (partially or fully) in the secondarymarket without recourse.

12. At maturity, the final holder(s) of the document(s) presentthem to the importer and, if unpaid, to the guaranteeing bankfor payment of the full face value of the document(s) , plusthe interest mentioned thereon.

NOTE: An aval is an unconditional guarantee placed on each of theindebtedness instruments, e.g. promissory note or bill of exchange.By placing an “aval” on the instrument, the bank commits itselfunconditionally to pay should the maker or drawee default. In thosecountries where an aval is not recognized by local law, the bank maygive a guarantee instead – usually on a separate document called a“letter of guarantee.”

Example As an example of forfaiting, assume an emerging markets customer(importer) wants six-year credit terms for a purchase totalingUS$6MM, to be delivered in four semiannual shipments. Theimporter is sufficiently creditworthy to get a local bank to grantone of the following:

n An unconditional bank guarantee to pay theholder of the debt obligation (forfaiter)

n An aval on the exporter’s bill of exchange thatguarantees payment

The forfaiter and the emerging markets customer togethernegotiate directly with the customer’s bank to determine whichdebt instrument will be used. Next, the forfaiter discounts the debtinstrument and, since the amount of the discount will be knownin advance, it can be included in the selling price of the order.

When the exporter presents a complete set of documentation provingthat the shipment has left, the forfaiter pays the exporter 100 percentof the selling price – less the discount if it was included in the sellingprice. Such payment is made within two days of the presentation ofshipping documents.

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The forfaiter then collects against the letter of credit directly from theemerging markets customer or from the customer’s bank.

When compared to bankers’ acceptance financing, forfaiting presentsseveral distinct advantages and disadvantages to the trading parties.

Advantages of Forfaiting

To the exporter The basic advantages of forfaiting to the exporter are the speed andsimplicity of the transaction. Additional advantages for the exporter(seller) include:

n Exporter receives immediate cash

n Avoidance of credit and country risks

n Improved business liquidity, reduced bank borrowing,and freedom to reinvest or use financial resources forother purposes

n Relief from administration and collection problems

n Simplicity and ease of arranging documentation

To the importer The basic advantage of forfaiting to the importer (buyer) is alsothe speed and simplicity of the transaction. In addition, forfaitingprovides the importer with a(n):

n Alternative form of financing

n Fixed interest-rate credit

n Increased and diversified borrowing capacity

n Rapid conclusion for a commercial contract

n Elimination of the administrative and legal costsassociated with credit loan agreements

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To the forfaiter The basic advantage to the forfaiter is that the transaction providesa crisp, marketable instrument with a bank obligation.

Disadvantages of Forfaiting

To the exporter The disadvantages to the exporter are:

n Need to ensure that the importer obtains a guarantorthat is satisfactory to the forfaiter

n May have to absorb part of the discount fromcommercial profit

To the importer The disadvantages to the importer are:

n Payment of a guarantee fee (higher costs) charged by theguarantor (e.g. bank)

To the forfaiter The forfaiter also is disadvantaged in several ways. These include:

n Risk of adverse interest rate changes (interest rate risk)

n Credit risk on the actual obligor / guarantor and/or relatedcountry risk

Required Documentation

As mentioned earlier, the documentation for a forfait is relativelysimple and quickly arranged. It consists of:

n A note or bill purchase agreement between the forfaiterand the exporter covering the terms and conditions ofthe purchase

n Bills of exchange (drafts) or promissory notes

n Letters of guarantee or aval

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n Signature confirmations

n Copies of exchange control approvals, if applicable

Summary

In this section, we examined the first of three export financingalternatives: commercial financing, which usually involves letters ofcredit, bankers’ acceptances, and forfaiting. We focused on bankers’acceptances and forfaiting.

A trade acceptance is a time draft that has been accepted by the buyerfor payment to the beneficiary at maturity. The payment ofthe time draft is not assured by a bank. A banker’s acceptance isa time draft that has been accepted by the bank for payment tothe beneficiary at maturity. It is a short-term credit instrumentcommonly used in international trade.

Forfaiting is a longer-term financing technique whereby the sellerreceives a discounted payment for its goods in exchange for thebuyer’s promissory note. It allows the seller to offer extendedterms to the buyer without having to wait for payment.

Before continuing to the remaining two export financing alternatives(ECA and private insurance-supported financing) in our discussion of“Types of Export Financing,” please complete Progress Check 3.2 toconfirm your understanding.

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Question 1: Which trade financing product involves the purchase of a debt instrumentwithout recourse to the party from whom it was purchased?

_____ a) Forfaiting

_____ b) Extension of credit

_____ c) Bankers’ Acceptance

Question 2: Bankers’ Acceptances are:

_____ a) generally used as medium-term credit for capital goods withmaturities ranging from six months to ten years.

_____ b) usually used by borrowers from foreign countries because theyprovide financing that is enforceable in the courts of the US andtheir home countries.

_____ c) popular as short-term investments and, therefore, among the leastexpensive short-term financing alternatives.

_____ d) short-term borrowings on demand that are used by customers whenthey have a series of transactions to be financed over a period of time.

Question 3: When the bank accepts a time draft, it:

_____ a) may sell the acceptance to a third party investor.

_____ b) eliminates credit risk.

_____ c) is eligible to discount the acceptance with the Federal Bank.

_____ d) extends credit to its customer for six months or more.

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ANSWER KEY

Question 1: Which trade financing product involves the purchase of a debt instrumentwithout recourse to the party from whom it was purchased?

a) Forfaiting

Question 2: Bankers’ Acceptances are:

c) popular as short-term investments and, therefore, among theleast expensive short-term financing alternatives.

Question 3: When the bank accepts a time draft, it:

a) may sell the acceptance to a third party investor.

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Question 4: Select two criteria of an “eligible” banker’s acceptance.

_____ a) Tenor of at least six months

_____ b) Self-liquidating

_____ c) Minimum annualized return of 10%

_____ d) Transactions limited to five types

_____ e) Merchandise in the “channels of trade”

Question 5: Which trade product is usually quoted with an “all-in” rate?

_____ a) Extension of credit

_____ b) Trade acceptance

_____ c) Banker’s acceptance

_____ d) Forfaiting

Question 6: Forfaiting improves business liquidity by allowing the exporter to:

_____ a) offer extended payment terms to the buyer while receiving cashimmediately.

_____ b) take advantage of floating interest rate financing.

_____ c) avoid paying the acceptance commission and passing its costs onto the buyer.

_____ d) receive an aval on the negotiable document.

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ANSWER KEY

Question 4: Select two criteria of an “eligible” banker’s acceptance.

b) Self-liquidating

e) Merchandise in the “channels of trade”

Question 5: Which trade product is usually quoted with an “all-in” rate?

c) Banker’s acceptance

Question 6: Forfaiting improves business liquidity by allowing the exporter to:

a) offer extended payment terms to the buyer while receiving cashimmediately.

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TYPES OF EXPORT FINANCING (Continued)

Export Credit Agency-Supported Financing

We have seen that the commercial financing of internationaltrade usually involves letters of credit, bankers’ acceptances,and forfaiting. We now look at a second type of export financingwhere governments, acting through their Export Credit Agencies(ECAs) and through Multilateral Agencies (MLAs), also facilitateinternational trade. They provide export financing both directly toborrowers and indirectly through cooperation with commercialbanks.

The involvement of ECAs and, to a large extent MLAs, dependson the:

n Types of risk of the importer’s country

n Nature and origin of the underlying exports and services

n Maturity of the financing required

n Acceptability of the borrower’s underlying credit structure

While ECA-supported financing is driven by the exporter’s country,MLA-supported financing is handled at the importer’s country.The MLA is a worldwide institution not associated with a localgovernment as in the case of ECAs. MLAs more often are involvedwith project financing rather than export financing. We discuss MLAsin greater detail later in this section.

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In Unit 1, we told you that ECA programs include guarantees,insurance for country and/or credit risk, guaranteed payment tocommercial banks, and preferential fixed interest rate. We nowlook at these characteristics in more detail.

ECA Guarantee and Insurance

Protectionagainst non-repaymentby buyer

The ECAs offer protection to the lender (or exporter) against non-payment by the buyer in one of two forms of coverage – guaranteesand insurance. A guarantee typically implies 100 percent protectionfor the covered risks in an event of default.

Insurance implies that the probability of coverage is less than 100percent, with the lender (insured party) remaining at risk for thepercentage not covered. Insurance is a contract between an insurerand an insured under which each has obligations to the other. Uponsatisfaction by the insured of its obligations, including documentingthat a claimable event has occurred, the insurer will pay the claim.Under either form of protection, the lender can choose to protectitself against country risk only or against both country risk and buyernon-payment (comprehensive cover).

Cash Payment Requirement

Minimum of15%

ECAs require from prospective buyers a cash payment equivalent toa minimum of 15% of the price of an export contract. This limits theECAs’ coverage to 85% of the export contract value.

Sourcing from Multiple Countries

National contentrequirements

For those export contracts involving the sourcing from multiplecountries, the export contract value includes all imported goodsand services contracted by the buyer, regardless of the supplier’ssourcing. In most cases, a country’s ECA supports only exportcontract values of its own country’s goods and services.

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Local Costs Financing

Limited to15% of exportcontract value

Many overseas projects involve substantial in-country installationor construction expenditures which must be provided by the exporteras part of his/her contract. Sometimes, such expenditures involvesourcing of construction services from the buyer’s country. Theseexpenditures may constitute a portion of the imported goods andservices eligible for export credit support. ECAs permit financingof identified local costs in amounts not exceeding 15% of exportcontract value. Only in such cases is ECA financing permitted tocover the equivalent of 100% of the country’s export contract value.

Example For instance, suppose a US exporter is awarded a contract totaling$120MM for supplying a turnkey power plant to China. The USexport contract value is $100MM and the $20MM balance of thetotal contract value is for building part of the plant’s infrastructure.

We know that EXIMBANK covers up to 85% of the US exportcontract value ($100MM) which, for this example, amounts to$85MM. The $15MM balance of the export contract value notcovered by EXIMBANK has to be covered by the local bank(s)in China. On the other hand, ECA covers part of the identifiedlocal costs not exceeding 15% of the export contract value. In ourexample, the ECA will cover $15MM out of the $20MM for thelocal expenditures and the risks of the remaining $5MM have to beassumed by commercial banks (local or international).

Funding Mechanisms

There are three major types of funding mechanisms for ECA-supportedexport financing dealing with short-, medium-, or long-term contracts. These are direct lending (co-financing), deposit /relending, and interest make-up. We examine the role of commercialbanks in each funding mechanism.

Direct Lending – The ECA lends directly to the buyer (importer)and, as a result, there are no financing earnings(spread) opportunity for banks.

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Deposit / Relending – The ECA lends to the bank which, in turn,re-lends to a borrower–buyer (importer).This funding approach offers banks attractivefixed interest-rate funds, but the ECA usuallylimits the spread that the bank can add.

Interest Make-Up – The ECA provides compensation to lendingbanks for the difference between marketrates of funding and the ECA’s concessionalterms for a specified export contract. Thelending bank and the borrower enter into anagreement to finance the export contract ata fixed interest rate over a time period. Thebank then enters into a separate agreementwith the ECA. The ECA compensates the bankfor the difference between its cost of fundingplus spread and the fixed interestrate on the loan to the borrower.

For instance, if the fixed interest rate onthe loan to the borrower is 7.0 % and if thebank’s price is 7.5% (LIBOR at 6.50% plusa 1.0% spread), then the interest make-upwould be 0.5% (7.5% - 7.0%).

Interest Rates: Floating and Fixed

Interest rates Lenders, whether they are financial institutions or exportersproviding deferred payment terms of sale, charge the buyer intereston the loan or deferred payment terms. For those financings coveredby an ECA guarantee or insurance, there is no restriction (floor orceiling) placed by the ECAs on the interest rate charged. The interestrate will be a reflection of the risks (country only or comprehensive)being covered by the ECA, the risks being assumed by the lender,and the pricing quoted by the competition.

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Lender / borroweragree on basis forcalculating rate

ECA-supported export credits can involve either a floating or afixed rate of interest. Whether the rate will be fixed or floating,the basis for calculating the rate is agreed upon between the lenderand borrower as part of the negotiations between these two partiesbefore the financing mandate is awarded to the lender.

Floatinginterest rates

Floating rates are adjusted periodically, usually semi-annually, onthe dates when repayment installments of the loan principal are due.Most medium term floating rate loans use LIBOR as the base forcalculation of the rate, and the lender then adds a pre-agreed margin(the spread) to the LIBOR rate to arrive at the “all-in” interest ratepaid by the borrower.

Fixedinterest rates

Fixed rates remain constant for the life of the financing. Financialintermediaries usually make fixed rate financing available for verylarge (greater than $50MM) financings. The rate, or the basis forcalculating the rate, is established between the lender and borrowerprior to any disbursements, usually prior to the loan documentationprocess.

CommercialInterestReferenceRate (CIRR)

Most ECAs provide official fixed rate financing support. The ECAshave established guidelines among themselves on how this fixedrate (called the Commercial Interest Reference Rate or CIRRrate) will be calculated so that the ECAs do not get into pricing wars.The CIRR rate used is typically the rate in effect at the time theECA approves the export transaction as eligible for its support. Thissupport may take the form of a direct fixed rate loan or an interestmake-up to financial intermediaries.

A direct fixed rate loan is one which the ECA makes directly to theborrower without using a financial intermediary. For an interestmake-up, the ECA provides the financial intermediary with acompensation for the difference between the CIRR rate (the ratecharged to the borrower by the lender) and the lender’s cost of fundsplus a small pre-agreed (with the ECA) spread. Under both the directloan and the interest make-up, the borrower is paying the CIRR rate.

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Risk-relatedexposure fees

All ECAs charge insurance premiums or guarantee fees to helpoffset future losses due to credit risk exposure. These fees may varywith country, credit risk, and with the duration of the transaction.

Insurance Coverage

If the exporter or lender is not prepared to take the country risk and/orcredit risk, the exporter should apply for insurance coverage.Insurance coverage, in turn, often determines the availability offinancing for the exporter.

For example, an ECA’s short-term program may provide insurancewhich can be used to obtain financing for the export of consumergoods, small manufactured items, spare parts, and raw materials.The medium-term insurance program may facilitate the financingof such capital goods and services as mining and refining equipment,construction equipment, agricultural equipment, telecommunications,computer equipment, and manufacturing equipment.

Types ofcoverage

ECAs offer coverage directly to a lender or to the exporter for certaincommercial and credit risks.

Commercial / credit risk refers to a borrower’s ability to generatesufficient local currency to purchase the necessary amounts of foreigncurrency to repay the financing.

Extent ofcoverage

In most cases, the insurance applies to a maximum of 85% of thecommercial contract. In certain cases, the percentage may be higher,but it applies to the contract value less any required cash payment.

For instance, the US ECA medium and long-term programs requirethe buyer to make a 15% cash payment. These programs cover up to85% of the contract value for items that are 100% US content but noless than 50%. The US ECA guarantees such items as US equipment,financing and legal fees (US-sourced and included in the contract),freight, insurance, and local costs (under certain conditions).

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Transaction Structures:Buyer Credit and Supplier Credit

In a typical transaction structure, an ECA financing extends creditto the importer either directly, through a Buyer Credit, or indirectly,through a Supplier Credit.

Buyer’s Credit Financing

Exporter’s banklends directlyto importer

In buyer’s credit financing, the exporter’s bank (e.g. Citibank)extends credit directly to a buyer (importer) of goods and services.The credit may also be fully or partially guaranteed or insured byan ECA. The cash payment (15%), if any, may be financed by theexporter or a bank, or paid in cash by the importer.

The supplier (exporter) and the buyer (importer) agree on thecommercial terms. The bank and the buyer agree on the financingterms. When the buyer receives the loan from the bank, the buyerpays the supplier. This process is shown in Figure 3.2.

Figure 3.2: Buyer’s credit financing

BUYING COUNTRYSELLING COUNTRY

Applies for / receivesinsurance policyand / or preferentialinterest rate

Establishcommercialterms of trade

Payment

1

3

Loanagreement /financingEstablish

financingterms

5

2

4

Supplier(Exporter)

Buyer(Importer)

CitibankExport Credit

Agency(EXIMBANK)

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Supplier’s Credit Financing

Importer’s debtinstrumentinsured by ECA

In supplier’s credit financing, the supplier (exporter) offers financingto the buyer (importer) by giving credit terms to the buyer. Thesupplier usually sells a receivable (e.g. promissory note or bill ofexchange) from an importer (buyer) to a bank for cash. An ECAguarantees or insures a portion of the receivable. The cash payment(15%), if any, may be financed by the exporter or a bank, or paid incash by the importer.

The step-by-step illustration of the process is presented in Figure 3.3.

Figure 3.3: Supplier’s credit financing

1. Once the buyer and the supplier agree on the commercial terms,the buyer issues promissory notes or bills of exchange in favorof the supplier.

2. The supplier accepts these notes and seeks insurance coveragefrom an ECA. The supplier is the original beneficiary of theinsurance policy or guarantee from the ECA.

BUYING COUNTRYSELLING COUNTRY

Applies for /receivesinsurancecoveragefor note / bill

2

3

Payment4

Sells note / bill andassigns insurancerights

Principal andinterest repaidat maturity

5

Promissorynote / bill ofexchange

1Supplier

(Exporter)

Export CreditAgency

Citibank

Buyer(Importer)

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3. The supplier sells the notes to a local bank and assignsthe rights of the ECA coverage to the bank.

4. The supplier receives a discounted payment, and thebank becomes the holder of the buyer’s obligation to pay.

5. The buyer repays principal and interest to the bank.

Exact terms and conditions offered by the ECAs frequently change.Trade officers need to be updated continually on current programs,policies, and rates offered by these agencies.

Organizationfor EconomicCooperationandDevelopment(OECD)

In Figure 3.4, below, we summarize the characteristics of some ofthe major export credit agencies. In this figure, we make referenceto the Organization for Economic Cooperation and Development(OECD) which is the international organization of the industrialized,market-economy countries. At OECD, representatives from Membercountries meet to exchange information and harmonize policy witha view to maximizing economic growth within Member countriesand assisting non-Member countries to develop more rapidly. Asof 1997, there were 29 Member countries.

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Country Export Credit AgencyDescription

Type ofCover

Program Currencyof Cover

Canada EDC – Export DevelopmentCorporation

Insurance Buyer &Supplier Credit

Canadian Dollars &US Dollars

France COFACE – Compagnie Françaised’Assurance pour de CommerceExterieur


French Franc or mainOECD currencies

Germany HERMES – HermesAusfuhrgarantien undbuergschaften


DM Contractsdenominated in USdollars are alsoinsured

Italy SACE (Export Credit Agency) –Sezione Assicurazione Crediti allaExportanzioneMEDIOCREDITO CENTRALE(Export Credit Funding Agency)

Insurance

Interestmake-up

Buyer &Supplier Credit

Italian Lira and mainOECD currencies

Japan J-EXIM – Export-Import Bank ofJapanMITI – Ministry of International Tradeand Industry

GuaranteeLendingInsurance


Japanese Yen andmain OECDcurrencies

Spain CESCE – Compania Española deSeguros de Credito a la Exportacion


Pesetas and mainOECD currencies

Sweden EKN (Export Credit GuaranteeAgency) – ExportkreditnämndenEKX (Export Credit FundingAgency) – Swedish Exportkredit

Insurance

Lending


Swedish Kronor andmain OECDcurrencies

UnitedKingdom

ECGD – Export Credits GuaranteeDepartment

Guarantee Buyer &Supplier Credit

British Pound andmain OECDcurrencies

UnitedStates

EXIMBANK – Export-Import Bank Direct LoanGuaranteeInsurance


US Dollar and mainOECD currencies

Figure 3.4: Export Credit Agencies by country: Type of Cover,Program, and Currency of Cover

Multilateral Agency (MLA)-Supported Financing

As you learned in Unit 1, indirect government aid is often associatedwith MLA-supported financing. MLAs are more involved in projectfinancing than financing for the export of goods and services.

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Project financing Project financing implies that the providers of finance look initiallyat the economics of a project such as projected cash flows, ratherthan the traditional financial strengths of the borrowers. Suchprojects are expected to generate sufficient cashflow to pay theinterest and repay the principal which originally supported theproject. Examples of suitable projects include power plants, mining,and telecommunications installations.

Depending on the complexity and size of the project to be financed,various sources of funding can be applied. Normally, several differentfunding sources are required to complete the financial package. ManyMLAs operate on a complementary basis with export credit agenciesand commercial sources. The involvement of MLAs adds credibilityto a project, thereby facilitating the process of raising financing.

MLAs recognize the need to select projects that bring economic valueto the importer’s country. Improved project selection by MLAs isregarded as an important policy step together with the introductionof new measures in macroeconomics management in the countriesconcerned.

Financingstructure

MLAs lend for periods of up to 20 years with grace periods of fiveyears and charge interest at a margin above their cost of funds.MLAs rarely finance 100% of a project: approximately 50% isa rough guideline for loans, equity, or guarantees.

Private Insurance-Supported Financing

Although ECAs insure many export transactions, the private sectoralso plays a role in providing coverage for country and limitedcommercial risks. We now look at this third type of export financing.

Private insurers primarily focus on short-term trade transactionsand are generally limited to terms of three years for medium-termtransactions. Some well-known insurers, which we describe in Unit 4,include Lloyds of London and Citicorp International TradeIndemnity (CITI).

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Private insurance coverage places no limitation on the nationalcontent of products. Military or paramilitary goods are acceptable ifthe trade transaction meets a bank’s credit policy approval. Insurancepolicy exclusions exist to limit coverage.

ContractFrustration forExportFinancing

The predominant policy type is Contract Frustration which coversnon-payment resulting from specific country risks. Coverage underthe Contract Frustration entitles the exporter to receive payment inthe following instances:

n Coverage usually requires the bank to take somepercentage of the risk

n Can be used to cover pre- or export financing orimport financing

n Can cover loans or drafts purchased as well as lettersof credit

EXPORT FINANCE: STRUCTURING THE DEAL

The structure of export financing (commercial, ECA-supported,or privately insured) ultimately will reflect the results of the creditand country risk analysis processes. We now present an examplethat illustrates how Citibank structures a deal that mitigates the risksassociated with the transaction while satisfying the financing needsof the customer. (This example also introduces the concept of risktransfer which we discuss in the next unit.)

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Example:Situation

Suppose a US exporter bids for the sale of $10 million of capitalequipment to a buyer in a developing country. The exporterrecognizes that, as in many international bidding situations, theterms of the accompanying financing proposal are a key factor inthe final bid selection. Since the exporter is unwilling to finance thepurchase for reasons of both liquidity and credit exposure, it turnsto Citibank to provide a complete financing package.

Risk analysis In this case, financing of the overseas buyer represents medium-or long-term commercial and country risk. In an attempt to reduceor eliminate these risks, Citibank may:

n Provide a buyer’s credit and cover portions of the riskthrough insurance or ECA guarantees which thenmake the asset more attractive for Citibank to retain

n Purchase the draft or promissory note from the exporterand sell it through the forfaiting market at a discountthat reflects the current market assessment of theunderlying risk

n Provide some combination of the above two options

Risk coverage options, however, often leave residual risks which mayinclude:

n Shortfalls of principal and/or interest coverage invarious insurance and guarantee programs

n Non-coverage of principal and interest for the 15%of the contract value which is usually required as adownpayment

n Possible exporter retention / recourse

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Option One — Buyer’s Credit Combined withInsuranceor ECA Guarantee

Assumption Citibank’s in-country branch will take the commercial risk of thebuyer and/or allocate cross-border facilities for a portion of thecontract value / purchase price. The branch, however, wants toleverage its limited cross-border availability.

Solution Citibank obtains a guarantee from the Export-Import Bank of theUnited States (EXIMBANK) covering 100% of the country andcommercial risk of non-payment on 85% of the contract value ofthe equipment. The buyer, however, requires financing for the fullpurchase price. Citibank’s ability to allocate cross-border exposure,as well as commercial risk to cover the 15% down payment, givesthe US exporter a competitive advantage in its bid to supplyequipment to the buyer. If the branch is unable to allocate 100%of the cross-border exposure, but can approve the commercial risk,Citibank may cover the 15% down payment portion with CITIinsurance.

Option Two — Forfait Market

Assumption Citibank’s in-country branch is unable to assume the commercialrisk and is unwilling to make a cross-border allocation available.

Solution After combining: (a) an EXIMBANK guarantee for the commercialand country risk that covers 85% of the contract value, with (b) localbank guarantee covering the 15% downpayment, Citibank workswith a forfaiter to sell the combined EXIMBANK and “clean-risk”asset through established distribution channels. Funds paid to theexporter may be discounted based on investor-required returns andthe nominal interest rate on the notes.

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Frequently, exporters will increase the contract price to the buyer tocompensate for receiving any discounted proceeds. If, however, thereturns required by investors make the all-in cost of purchasing theequipment too expensive for the buyer, the exporter may be willing tosubsidize this return or retain a nominal risk exposure in order tosecure the commercial contract.

Summary

In Unit 2, we discussed payment options and the documents neededfor international trade transactions. In the “Commercial Financing”section of this unit, we examined two trade financing products —banker’s acceptance and forfaiting. Then, in this section, we looked atthe specific structures available for export financing through ECAs,MLAs, and private insurers. All of these banking activities oftenrequire the cooperation of more than one bank.

In the next section, we further describe how banks cooperate toprovide trade financing to their customers. We examine the uniqueworking relationship among banks as well as three trade products thatrequire a correspondent banking relationship.

CORRESPONDENT BANKING

Service theneeds of globalcustomers

While banking is a highly competitive industry, members of thebanking community are active customers of one another and oftenassist each other with different aspects of their business. If a bankdoes not have branches in countries where its customers conductbusiness, it arranges with banks in those countries to service theforeign needs of its customers.

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Relationship Among Banks

A bank that performs banking services for another bank is known asa correspondent bank. Services performed by correspondent banks(including the transfer of funds, trade transactions, financing, andperhaps an account relationship) provide the foundation forinternational banking.

Banks initiating a correspondent relationship must agree to theterms and conditions that will apply to transactions conductedbetween them. The banks must exchange their signature books andtest keys in order to validate the contents of future communications.(Signature books are used to verify customers’ signatures. Test keysare used to establish the authenticity of instructions from bank tobank. They generally consist of tables of numbers that are used toindicate date, currency, amount, and other information.)

There are different ways a bank can provide worldwide servicesfor its customers. Sometimes international banks seek local banks tomeet their local business needs. Local banks look to theinternational banks to provide coverage for their offshore needs.

Let’s look at some of the products that require a correspondentbanking relationship.

Products

Citibank has developed three products to use with correspondentbanks who have the capacity to approve country risk, and to someextent, commercial risk, but lack an origination capability. Eachproduct requires working out an agreement between Citibank and thecorrespondent bank.

The three products are:

n Letter of credit confirmation

n Nonsovereign funding

n Participations

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Let’s examine Citibank’s role in each of these products.

Letter of Credit Confirmation

Standard clause Citibank has a standard clause which is a pre-agreement betweenCitibank and the confirming bank abroad. It addresses the issues ofcountry and commercial obligation in letters of credit opened by anyof its branches worldwide. The clause states that the obligations ofthe Citibank branch will be performed under the regulations of thecountry in which it is located, and the correspondent bank cannotgo against Citibank NY for the fulfillment of such obligations. Theclause allows the Citibank branch to operate as a typical localprivate bank in the country. The wording of the clause cannot beamended without prior legal counsel and country risk approvals thatcome from the Head Office. The clause does not apply when thecorrespondent bank is another Citibank branch.

Nonsovereign Funding

While correspondent banks may be prepared to take the countryrisk, they may be unable to cover the specific commercial risk of theborrowers. Citibank has developed a product to address this concern.There are two methods for nonsovereign funding.

1. In Figure 3.5, the Citibank branch borrows from an(offshore) correspondent bank and lends to a local importeror exporter (borrower). The branch issues a financingagreement with a disbursement request. The borrower signs apromissory note in favor of the local branch. Assets andliabilities are registered on the local books.

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(Offshore) CorrespondentBank

Country A

Country B Borrows

CitibankBranch

Lends Importer /Exporter

(Borrower)

Signs promissory note

Figure 3.5: Transaction recorded on the local books

2. In Figure 3.6, the Citibank branch uses an offshore bookingcenter, such as the IBF, to book its import /export financings. The correspondent bank depositsthe funds in the offshore booking center account andacknowledges that the funds will be lent directly to theimporter / exporter. There is a disbursement request anda promissory note signed by the obligor (borrower) to theoffshore booking center that is acting as the lender. Withthis method, all entries are done at the offshore unit level.Because the local Citibank branch is not legally involved inthe transaction, the transaction is not recorded on thelocal books.

CorrespondentBank

Deposits

OFFSHOREBooking Center

Country A LendsSignspromissorynote

Country B

CitibankBranch

Importer /Exporter

(Borrower)

Figure 3.6: Transaction not recorded on the local books

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Nonsovereignfunding risks

For both methods, the correspondent bank assumes: (1) the countryrisk of the country of the Citibank branch or the borrower and (2)the Citibank N.A. commercial risk.

A copy of the standard financing agreements, and further details onthese procedures, may be obtained from the product specialists orthe managers involved with country risk.

Participations

Silent /nonsilent

Correspondent banks may be prepared to take a certain percentageof Citibank’s exposure to the country and commercial risk of theborrower. The participation may be silent if the borrower has notbeen informed of the action. If the lender informs the borrower thatthe correspondent bank is taking a percentage of the exposure, thenthe participation is nonsilent or open.

The difference between a participation and a discount, sale, or forfaitfinance of the note is that, with participation, the branch remains theoriginal lender; however, the amount of exposure is reduced. Even ifthe correspondent bank’s participation is 100%, the lender remainsthe same and all communications and negotiations are done with theoriginal lender (branch).

The participation may include a:

n Percentage of country risk (political, convertibility,and transfer)

n Percentage of commercial risk

n Combination of both risks

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There is an alternative that applies only to country exposure. Thecorrespondent bank agrees to pay the full amount of the obligationat its maturity only if the lender (Citibank) cannot collect becauseof a country risk event. In this situation, the document signed is an“unfunded participation agreement” that operates like an insurancepolicy. The “insured party” pays a fee to the correspondent for suchcoverage and funds the lending alone. It is very important to analyzethe risk of the correspondent bank. Citibank has defined that only“AA” correspondents may be used for this alternative and a creditapproval must be received from the correspondent bank’s Citibankcredit control unit.

UNIT SUMMARY

In the beginning of this unit, you learned important factors on whichthe Bank bases decisions to extend credit to customers, as well as thetypes of rates, terms, and conditions that may be applied to a creditextension. We then examined four purposes for trade financing.

Next, you were introduced to two trade financing products —banker’s acceptance and forfaiting. We also discussed therelationships that banks maintain with other banks, with ECAs, MLAs,and with private insurance providers to facilitate export financing andother international trade transactions.

Depending on the risks involved and the nature of the transaction,banks may require the support of ECAs in the form of insurance,subsidies, and/or guarantees for buyers’ or suppliers’ credit financing.ECAs provide deposit / relending, discounting, and interest rate make-up programs to commercial banks, as well aslend directly to importers and exporters.

MLA financing is often associated with long-term financing forprojects that bring economic value to the importer’s country.

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Private insurance often covers the commercial and country risks forexport financing transactions which are not insured by ECAs, MLAs,or other government entities.

Correspondent banking is a relationship among banks that is oftenrequired for international trade transactions. Three trade products thatinvolve correspondent banking were identified: 1) letter of creditconfirmation, 2) nonsovereign funding, and 3) participations.

You have completed Unit 3: Trade Finance. Please complete Progress Check 3.3 to testyour understanding of the concepts and check your answers with the Answer Key. If youanswer any questions incorrectly, please reread the corresponding text to clarify yourunderstanding and then continue to Unit 4: Risk and Compliance.

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Question 1: Place a T in front of the statements which are true and an F in front of thestatements which are false.

_____ Direct extensions of credit to exporters are granted only by importers.

_____ A small exporter’s best option for securing short-term pre-export financingis a commercial lender.

_____ Bankers’ acceptances are the instruments used by suppliers to offerECA-supported financing to buyers.

_____ In a buyer’s credit financing, Citibank lends directly to the buyer.

_____ Commercial banks may receive interest-rate subsidies from export creditagencies for specific export contracts.

_____ In a buyer’s credit financing, the buyer is assigned the rights to the ECA’sinsurance policy.

_____ Export credit agencies compensate commercial banks for preferentialfixed rate financings for certain export contracts.

_____ A country’s export credit agency may focus on short-, medium-, or long-term contracts to promote the exporting sector of its country.

_____ Multilateral agencies focus on short-term contracts that promote theexporting sector of developed economies.

Question 2: A US exporter provides financing, insured by EXIMBANK, to an importer ina Latin American country. The exporter sells the buyer’s promissorynote and assigns the insurance policy rights to Citibank in exchange forimmediate payment. The buyer repays the principal and interest to:

_____ a) the supplier.

_____ b) EXIMBANK.

_____ c) Citibank.

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ANSWER KEY

Question 1: Place a T in front of the statements which are true and an F in front of thestatements which are false.

F Direct extensions of credit to exporters are granted only by importers.

T A small exporter’s best option for securing short-term pre-export financingis a commercial lender.

F Banker’s acceptances are the instruments used by suppliers to offer ECA-supported financing to buyers.

T In a buyer’s credit financing, Citibank lends directly to the buyer.

T Commercial banks may receive interest-rate subsidies from export creditagencies for specific export contracts.

F In a buyer’s credit financing, the buyer is assigned the rights to the ECA’sinsurance policy.

T Export credit agencies compensate commercial banks for preferentialfixed rate financings for certain export contracts.

T A country’s export credit agency may focus on short-, medium-, or long-term contracts to promote the exporting sector of its country.

F Multilateral agencies focus on short-term contracts that promote theexporting sector of developed economies.

Question 2: A US exporter provides financing, insured by EXIMBANK, to an importer ina Latin American country. The exporter sells the buyer’s promissorynote and assigns the insurance policy rights to Citibank in exchange forimmediate payment. The buyer repays the principal and interest to:

c) Citibank.

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Question 3: In a buyer’s credit financing, the financing terms are negotiated by the:

_____ a) buyer and seller.

_____ b) buyer, buyer’s bank, and MLA.

_____ c) buyer and buyer’s bank.

_____ d) buyer and ECA.

Question 4: Export Financing for a USD 250,000 sale of US computer parts to animporter in a developing country is most likely to involve a(n): (Selectall that apply).

_____ a) buyer’s credit financing.

_____ b) EXIMBANK insurance.

_____ c) line of credit from Lloyds of London.

_____ d) discounted purchase by a forfaiter of a bill of exchange drawn onthe exporter, due to mature in 30 days.

_____ e) banker’s acceptance.

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ANSWER KEY

Question 3: In a buyer’s credit financing, the financing terms are negotiated by the:

c) buyer and buyer’s bank.

Question 4: Export Financing for a USD 250,000 sale of US computer parts to animporter in a developing country is most likely to involve a(n): (Selectall that apply.)

a) buyer’s credit financing.

b) EXIMBANK insurance.

e) banker’s acceptance

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Question 5: In a trade transaction that involves payment by confirmed letter of credit,the issuing bank, confirming bank, and paying bank are most likely to be:

_____ a) insured by an export credit agency.

_____ b) correspondent banks.

_____ c) discounting trade receivables with EXIMBANK.

_____ d) sharing a percentage of the acceptance commission rate.

Question 6: ECAs offer interest rate make-ups to facilitate import financing by:

_____ a) compensating lending banks for the difference between marketfloating interest rates and preferential fixed interest rates.

_____ b) allowing banks to sell promissory notes to an ECA at an appropriatediscount rate.

_____ c) providing a pool of attractive fixed-rate funds.

_____ d) guaranteeing the debt instrument(s) of the borrower.

Question 7: Match the name of the export credit agency with the country it represents.(A country may be represented by one or more agencies.)

_____J-EXIM a) Italy

_____ECGD b) United States

_____COFACE c) Germany

_____SACE d) Japan

_____EXIMBANK e) United Kingdom

_____HERMES f) France

_____MITI

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ANSWER KEY

Question 5: In a trade transaction that involves payment by confirmed letter of credit,the issuing bank, confirming bank, and paying bank are most likely to be:

b) correspondent banks.

Question 6: ECAs offer interest rate make-ups to facilitate import financing by:

a) compensating lending banks for the difference between marketfloating interest rates and preferential fixed interest rates.

Question 7: Match the name of the export credit agency with the country it represents.(A country may be represented by one or more agencies.)

d J-EXIM a) Italy

e ECGD b) United States

f COFACE c) Germany

a SACE d) Japan

b EXIMBANK e) United Kingdom

c HERMES f) France

d MITI

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Question 8: The correspondent banking system consists of:

_____ a) local banks that provide funding to each other.

_____ b) banks that provide guarantees and assume risks for their branches inother countries.

_____ c) banks that perform services for other banks.

_____ d) on-line test keys that are used to verify customers’ signatures.

Question 9: Place an X in front of the products that are commonly used in correspondentbanking.

______Confirmation of letters of credit

______Open account

______Participations

______Nonsovereign funding

______Forfaiting

______Cash in advance transaction

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ANSWER KEY

Question 8: The correspondent banking system consists of:

c) banks that perform services for other banks.

Question 9: Place an X in front of the products that are commonly used in correspondentbanking.

X Confirmation of letters of credit

Open account

X Participations

X Nonsovereign funding

Forfaiting

Cash in advance transaction

Unit 4

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UNIT 4: RISK AND COMPLIANCE

INTRODUCTION

Two particularly important considerations in international trade are the inherent risks inthis type of business and compliance with international rules, regulations, and laws. Inthis unit, we identify the different risks that affect trade transactions, describe howCitibank manages risk, and present the US rules, regulations, and laws requiringcompliance. Insurance programs that provide protection from the risks inherent ininternational trade also are explained. The informed banker understands these elements,how they affect international trade, and how to provide the safest and most appropriatetrade products to the customer.

UNIT OBJECTIVES

Upon completing Unit 4, you will be able to:

n Identify the risks for Citibank in trade transactions

n Recognize methods that Citibank uses to manage and transfer risk

n Recognize legal and regulatory obligations to which Citibankmust conform

n Understand the application of US sanctions, US anti-boycottregulations, US export controls, and anti-money launderingregulations

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RISKS FOR THE BANK

When trade is conducted between countries, a range of risks canaffect the success of the transaction. For example, changes ineconomic or political conditions may affect the repayment of a loan.In Units 2 and 3, we mentioned some of the risks associated withtrade services and trade finance. In this section, we will define, inmore detail, the credit, country, and other risks associated withinternational trade (Figure 4.1).

Figure 4.1: Categories of trade-related risk

* NOTE: According to the Citicorp Core Credit Policy (C.C.C.P.) (revised June,1997), Convertibility Risk and Transfer Risk are both known as Cross-Border Risk.

Lending

Direct

Contingent

Counterparty

Presettlement

Settlement

Product

Operational /Systems

Legal andRegulatory

Documentation

Image

Performance

Political

Convertibility

Transfer

CREDITRISK

COUNTRYRISK*

OTHERRISK

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Credit Risk

Customer-related risk

Credit risk (also known as commercial risk) is a customer-related riskthat reflects the customer’s ability to fulfill all obligations to the Bank.(An obligation is the responsibility to pay a sum of money or performsome act when due.) The possibility that a borrower may be unableto repay a loan on time or in full, resulting in a financial loss for theBank, constitutes a credit risk. Credit risk for the Bank falls into twocategories: lending and counterparty.

Lending Risk

Lending risk involves extensions of credit and/or credit-sensitiveproducts (loans and overdrafts) where the Bank takes the full risk forthe entire life of the transaction. The two types of lending risk aredirect and contingent.

Not settledon time

Direct lending risk is the possibility that customer obligations willnot be settled on time. Direct lending risk occurs in products such asloans, overdrafts, credit cards, and residential mortgages. One tradeproduct that incurs direct lending risk is bankers’ acceptances. Therisk exists for the entire life of the transaction.

Potentialobligationsbecome actualobligations

Contingent lending risk is the possibility that potential customerobligations will become actual obligations and will not be settledon time. Contingent lending risk occurs in such products as lettersof credit and confirmations of letters of credit.

Counterparty Risk

A counterparty is a customer with whom the Bank has a contract tosimultaneously pay agreed values at a stated future date. The riskthat a counterparty may default occurs either before the settlementdate or at maturity of the contract.


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Default beforesettlement date

Presettlement risk (PSR) is the risk that a counterparty with whomthe Bank trades may default on a contractual obligation to the Bankbefore the settlement date of the contract. Two conditions arerequired for the Bank to recognize a loss on a contract:

n Counterparty defaults (or declares bankruptcy)

n Contract has positive market value to the Bank

Presettlement risk is measured in terms of the potential replacementcost — the potential economic consequences to the Bank — if adefaulted contract has to be replaced.

Default onsettlement date

Settlement risk occurs on the maturity date when the Banksimultaneously exchanges funds with a counterparty but cannot verifythat payment has been received until after the Bank’s sideof the transaction has been delivered.

In today’s international banking environment, the different timezones between countries make it difficult to achieve a simultaneousexchange between counterparties. If the Bank delivers its side ofthe transaction, but does not receive delivery, it is exposed to directlending risk. In this situation, at least 100% of the principal is atrisk. The risk may be larger than 100% if there has been an adverseprice fluctuation for the Bank between the contract price and themarket price.

Country (Political and Cross-Border) Risk

In addition to customer-related credit risk, the particular country /countries involved in an international trade transaction present risksto the Bank.


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Political oreconomicinstability

Country risk is the possibility that the country in which the Bankhas business dealings may experience internal instability thatreduces the offshore lender’s ability to collect in a timely manner.Economic problems, political disturbances, or sovereign actionswithin a country may make it impossible to get money or physicalassets out of that country. In some cases, it may become impossibleto convert local currency into a foreign currency. Country riskincludes political (sovereign) and cross-border (transfer andconvertibility) risk.

Political (Sovereign) Risk

Governmentactions orindependentevents

Political (sovereign) risk is the possibility that the actions of asovereign government (e.g., confiscation, expropriation ornationalization) or independent events (e.g., wars, riots, civildisturbances) affect the ability of customers in that country to meettheir obligations to Citibank. Political risks are most significant intransactions between a developed and an emerging-market country.

Transfer Risk

Inability to movefunds

Transfer risk exists in any transaction in which the borrower may beunable, due to legal or other barriers, to transfer funds in the foreigncurrency of payment to the place of payment when its obligation inthat currency matures.


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Convertibility Risk

Inability toexchange localcurrency forforeign currency

Convertibility risk exists in any transaction in which legal orregulatory barriers may prevent the borrower from converting his/her local currency into the foreign currency required for paymentwhen the obligation in that currency matures. Convertibility riskis inherent in any transaction that requires a flow of funds throughan exchange control barrier such as a country’s central bank.

This risk does not refer to devaluation of currency; rather, it reflectsthe risk that the local currency will be inconvertible. Less-developedcountries usually are short of hard currencies. Therefore, an importermay experience delays or an inability to convert the local currency tothe currency of the exporter for payment.

Example For example, let’s say that Egypt has accumulated French Francslocally as a result of a prior trade transaction and wants to usethese funds to pay a multinational construction company for alocal construction project. Although the deal is denominated inFrench Francs, a liquid currency which can be hedged, an Egyptianbank involved in the transaction runs the risk associated with itsresponsibility for getting the money out of Egypt. (The Egyptiangovernment may create a transfer risk situation if the governmentprohibits the transfer of French Francs out of the country.)

Note that when an overseas branch of Citibank does business inthat country, there is no convertibility risk if the trade finance isfunded locally (e.g., use of hard currency from local deposits).There would have been cross-border risk if the transaction had beenfunded offshore (e.g., a loan from an International Banking Facilityto the branch).


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Other Risks

Credit and country risk are the two primary risks the Bank dealswith in international trade transactions. Other risks that must beconsidered include image, product, operational / systems, legal andregulatory, documentation, and performance risk.

Image Risk

Damage tothe Bank’sreputation

Image risk is the possibility that some activity of the Bank or oneof its representatives damages the reputation of Citibank. One wayto protect the Bank is to maintain confidentiality at all times! Inaddition, Citibank avoids financing products or services, such asmedicines and weapons, that may damage the Bank’s reputation.Trade products that may produce image risk include letters of credit,bankers’ acceptances, documentary collections, and bank-to-bankreimbursements.

Bank-to-bank reimbursement is a trade product that is used whenthe letter of credit transaction between the applicant and beneficiaryfrom different countries is denominated in a third-country currency,usually US dollars. The reimbursing bank pays the advising /negotiating bank in the currency stated in the letter of credit andbased on the reimbursement authorization issued by the issuing /opening bank. The reimbursing bank charges a fixed fee to eitherthe issuing / opening bank or the beneficiary and represents avaluable source of income for Citibank.

Product Risk

Faulty orinadequatetrade productor service

Product risk is the risk that the structure of a certain trade product orservice is inadequate or faulty. Letters of credit, bankers’ acceptances,documentary collections, and bank-to-bank reimbursements are tradeproducts that have this risk. Guidelines and quality standards forhandling trade transactions help alleviate product risk.


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Operational / Systems Risk

Failure ofinternal /externalprocessingsystems

Operational / systems risk refers to risks associated with thefunctional aspects of the products. This risk is high in tradetransactions due to reliance on the manual examination of documentsand bills and the use of technology.

Example Operational / systems risk may be internal or external to the Bank.For instance, in a money transfer system there is a risk associatedwith an external system. When the Bank transfers funds by wire,it may use private international communications systems such asthe Society for Worldwide International FinancialTelecommunications (SWIFT). There is always a risk that adisruption of services may prevent or delay the transfer.

Legal and Regulatory Risk

Noncompliancewith regulations

Many legal and regulatory factors affect trade transactions. Theseinclude foreign currency laws, local legal lending limits, USsanctions, and US anti-boycott regulations and taxes. (We lookat some of these compliance issues later in this unit.) When atransaction does not comply with all applicable laws and regulations,the Bank may face civil, criminal, and administrative proceedings.Trade products that carry legal and regulatory risk include: letters ofcredit, bankers’ acceptances, documentary collections, and bank-to-bank reimbursements.

Documentation Risk

Incorrect orunenforceabledocumentation

Written instruments such as legal forms, receipts, and applicationsare required to enforce the Bank’s rights under contracts ortransactions. Documentation risk is the possibility that theseinstruments are incorrect, incomplete, or unenforceable.


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Performance Risk

Failure ofexporter toperform

Performance risk is the possibility that an exporter may fail toperform under the contract established with the importer. Forexample, if an exporter does not deliver critical parts or sendsunacceptable parts, the importing manufacturer may be unable toproduce his or her final product. The exporter’s performance failureaffects the importer’s ability to generate cash from the sale of goodsand repay his or her obligation to Citibank.

Risks in a Trade Finance Transaction

You have read about the risks associated with trade transactions. Asyou continue with the following example of a simple trade financetransaction, try to identify some of the risks Citibank will incur.

Example An exporter in Italy receives an advance payment of US $7MM fromCitibank, New York, for goods that will be shipped to a US importerbeginning in nine months. The US importer agrees to pay theprincipal amount in US dollars to Citibank, NY upon receipt of theshipments. The exporter agrees to pay the interest by convertingItalian Lira into US dollars through the local Citibank branch, whichwill remit the interest payments to Citibank, NY.

Shipments to the importer begin in nine months and take place overa period of two months. For each shipment received, the importerhas thirty days to remit the corresponding payment to Citibank, NY.In the meantime, the exporter pays Citibank, NY, 10% per annuminterest on the balance due. This rate is a function of the risksassociated with the transaction and the cost of mitigating the risks.

For Citibank, the risks associated with this transaction are:

n Credit Risk: Risk that the exporter is unable to produce thegoods or pay the interest on the balance due and the risk thatthe importer refuses or is unable to pay the principal amount.


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n Political (Sovereign) Risk: Risk that the exporter isunable to export due to local government actions such asconfiscation, expropriation, or nationalization

n Convertibility Risk: Risk that the exporter is unable toconvert local currency to US dollars to pay interest on thebalance due

n Legal and Regulatory Risk: Risk that the importer isunable to clear goods through customs for import due toquotas or failed Food and Drug Administration (FDA)inspection

RISK MANAGEMENT

You have seen that international business primarily involves creditand country risks. Assessing and undertaking commercial risk isthe traditional role of banks and, as you learned in Unit 3,banks have established standard practices for determining thecreditworthiness of customers. Banks that finance internationaltrade also must analyze the country risk of the obligor’s country orcountries involved in the transaction. In this section, we will lookat the process Citibank uses to establish risk allocations for targetmarket countries and describe some of the techniques Citibank usesto manage this risk.

Allocating Cross-Border Risk

Control unit Citibank manages country risk through its branch network. TheCountry Senior Credit Officer (CSCO) and the branch in a countryrepresent the control unit for that country. If there is no branch in aparticular country, the nearest division office becomes the controlunit. For example, Citibank Nairobi serves as the control unit forKenya and for the other English-speaking countries in the regionwhere there is no branch office.


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Cross-borderallocationsfor country /region

The CSCO is responsible for assessing the political and economicrisk of the particular country or region. Based on that assessment,the CSCO proposes to the Citibank Head Office a specific cross-border allocation for the country. The CSCO’s proposal includes a:

n Suggested limit on the total amount of cross-borderbusiness which Citibank should do with that country

n Description of the recommended type of cross-border business

For example, the CSCO may recommend that the Bank confirmletters of credit from a country, but should refrainfrom any direct lending to the country.

n Recommendation for tenors attached to each type of business

Control unitmanages limit

Regardless of where a transaction originates, Citibank limits theamount and type of business that can be done cross border withany particular country. The local control unit in each countrymanages that limit. For example, if a Relationship Manager in NewYork has a customer who wants payment under a confirmed letter ofcredit for exports to Argentina, the control unit in Buenos Aires mustapprove the transaction. This approval process is called allocatingcross border.

A comparison with a standard line of credit for companies orindividuals may help you understand how this allocation is managed.A company or individual has pre-established credit limits basedon its financial condition. Once a company has reached its pre-established credit limits, no new transactions are possible until someportion of the line has been repaid. In the case of country risk, thelimits are based on an analysis of political and economic conditionsof a country, rather than on the balance sheet fundamentals of acompany or individual.


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Businessrestrictedby limits

Citibank’s ability to generate new business worldwide often strainsthese cross-border limits. The Bank potentially can originate moretransactions with companies wanting to do business in countrieswith cross-border limits than it is capable of serving based on riskallocation alone.

Example For example, the control unit in Brazil set a total cross-borderlimit of $600 million for 1995. This means that companies outsideBrazil who wanted Citibank to participate in their Brazilian tradetransaction would have been unable to use Citibank if the totalof the Brazilian deals on Citibank’s books worldwide equaled$600 million.

This tension between Citibank’s ability to generate new businessand restrictions resulting from cross-border limits has led to thedevelopment of risk transferring techniques. In the next section,we define and illustrate the risk transfer process.

RISK TRANSFER

Shift of countryand/orcommercialrisks

Risk transfer essentially involves finding ways to shift the country(political and cross-border) and/or commercial risks of internationaltrade. The goals of risk transfer are to (1) help our customers dobusiness in countries which present unique opportunities andspecialized potential problems and (2) earn significant fees withoutexceeding Citibank’s own risk constraints.

Risk Transfer Through Syndication

Example:syndication

To help you understand the risk transfer process, let’s look at anexample that illustrates how Citibank uses syndication to handlea deal that exceeds the cross-border limit for a country.


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A British company wants to export tea to Egypt. Due to the cross-border risk associated with the deal, the exporter wants paymentunder a confirmed letter of credit. Citibank is asked to confirm theletter of credit, but the amount exceeds the cross-border limitestablished for Egypt.

Recall that syndication (discussed in Unit 3) is the process oftransferring risk by splitting the risk into several parts and findinginvestors who want to share that risk. Without some transfer of risk,Citibank cannot effect the transaction. By bringing other investorsinto the transaction, Citibank is able to accept the business.

In this case, Citibank asks five banks to share the cross-borderrisk (transfer and convertibility risk), with each taking a differentpercentage of the total in return for a proportionate share of thefee for providing the letter of credit. In addition, Citibank takes a feefor originating the deal and bringing it to the investors. If the issuing(Egyptian) bank defaults for political reasons, each bank pays onlythe portion of the letter of credit amount which it agreed to accept.

Transfer ofcross-borderrisk

Cross-border deals typically separate the credit risk from the cross-border risk of the deal. Citibank usually keeps the commercial riskand syndicates the cross-border risk. Let’s see how this works.

Silentsyndications

Risk transfer syndications may be “silent” or “open.” In a silentsyndication, the customer does not know that there are otherinvestors in the transaction. Citibank accepts the risk of the entiretransaction and then sells pieces of the deal to other banks. Citibankalso sets the fees for the deal. Citibank bears the counterparty anddocumentation risk. If Citibank sells a portion of the deal to a bankwhich then defaults on its portion of the deal, Citibank is responsiblefor that amount. The advantage to Citibank is that it receives a feefor committing the funds and then sells the deal at a spread in orderto retain a portion of the fees that are paid to the other banks.


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Opensyndication

In an open syndication, the investing banks act as a consortium.The lead bank manages the transaction, but all the banks aredisclosed to each other and to the customer. The customer mustassess the counterparty risk of each participating bank because thecustomer, rather than Citibank, bears the risk. If one of the banksdefaults on its obligation, the customer bears the loss. Citibank isnot responsible for the whole transaction, even though it may be thelead bank that arranged for the syndicate.

Investors in Risk Transfer Transactions

We have already mentioned one transfer risk technique, syndication.In this section, we will examine other techniques in the context ofthe parties investing in risk. These parties include banks, insurancecompanies, export credit agencies, and other investors.

Banks

Preferredinvestors forsyndications

Banks represent about 50% of the market for risk transfer. They arethe preferred investors in risk transfer transactions because they tendto evaluate deals in the same way as Citibank. Other banks also havesimilar documentation needs and approaches to investment. As wediscussed earlier, banks invest in risk through syndications.

Insurance Companies

Write policies Like banks, insurance companies are significant investors in the risktransfer market, accounting for about 40% of the total. Insurancecompanies, however, differ from banks in the way they invest inrisk. They invest by writing policies in which there is a beneficiarywho submits a claim in the event of a default.


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For example, suppose that Citibank accepts the country risk of adeal in a less developed country and transfers that risk through aninsurance policy. In the event of default for political reasons coveredunder the policy, Citibank will make a claim on the insurancecompany and receive payment.

The field of trade-related insurance addresses trade credit risk aswell as country risk.

Trade credit risk Trade credit insurance is used to protect receivables from awide range of risks, including the actions of private obligors andsovereign governments. Trade credit insurance provides financialprotection against political instability, regional or global economicproblems, and natural disasters that may affect goods in transit.

Country risk Country risk insurance is used to protect against losses resultingfrom actions or inaction of a sovereign government. Country riskinsurance is not a financial guarantee since it does not covercommercial risk. For example, it may be used when cross-borderexposure becomes a constraint to the trade transaction. Countryrisk insurance covers:

n Currency inconvertibility and/or non-transfer

A government blocks conversion or transfer of currency(This is not devaluation risk.)

n Contract frustration

A government entity defaults on or blocks the deal

n Confiscation, expropriation, nationalization (CEN)

A government seizes the investment

n Unfair calling guarantee

A government unfairly calls the performance bond


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The insured must maintain confidentiality about the insurance.Claims are payable after a specified “waiting period.” We describebelow two such insurance providers: CITI and Lloyds of London.

CITI Citicorp International Trade Indemnity, Inc. (CITI) is a Citicorpbusiness that provides trade-related insurance (political risk, tradecredit risk, and marine cargo). CITI’s customers include importers,exporters, contractors, manufacturers, financial institutions, andinsurance intermediaries. Anyone who has a stake in the flow ofcapital and commerce across borders can benefit from the servicesoffered by CITI.

Lloyds ofLondon

Lloyds of London, a 300-year old association in London, originallyprovided marine insurance. Its members — composed of merchants,ship owners, underwriters, and brokers — underwrite policies foreach other. It is the largest insurance marketplace in the world.

Lloyds of London provides:

n Direct insurance (property / casualty)

n Indirect insurance or reinsurance(country risk, transportation)

n Catastrophe reinsurance

Export Credit Agencies (ECAs)

You learned in Unit 3 that most developed countries havegovernment agencies that promote exports, particularly exports toemerging-market countries. The export credit agencies (ECAs) useeither guarantees or insurance to help the exporting company coverthe commercial risk of the overseas importer and the country riskof the importer’s country.


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Typically, Citibank originates a transaction and then contacts therelevant ECA to arrange some form of risk transfer (insurance orguarantee). The ECA accepts a majority portion (but not all) of therisk and the transaction proceeds. The Bank structures these deals.One of Citibank’s strengths is its ability to interact with all of thekey ECAs in order to ensure the success of these transactions.

Example Here is an example of the process. A US exporter wants to sellcapital equipment to Venezuela. The exporter — a Citibankcustomer — requests that Citibank confirm the letter of credit for theequipment. Since Citibank does not want to accept the entire countryrisk (perhaps it will exceed its Venezuelan cross-border limit),Citibank requests cross-border guarantees from the US EXIMBANK.EXIMBANK issues the guarantee for 85% of the country risk,leaving Citibank with 15%. In the event of default for politicalreasons, Citibank will retrieve from EXIMBANK the 85% portionthat has been guaranteed. The remaining 15% is Citibank’s risk.

Other Investors — Forfaiting

As we saw in Unit 3, forfaiting involves the sale without recourse ofa cross-border receivable from an exporter. Essentially, forfaiting isa technique that transfers to investors the commercial and countryrisk of the overseas buyer, the obligor. The commercial risk may bemitigated somewhat by a bank guarantee on the paper (although theinvestor now bears the bank’s risk rather than the importer’s risk).


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Primary investors in the forfait market are merchant banks, forfaitinghouses (specialists in trading these investments), and forfaitingdepartments of banks. These investment houses typically establishnetworks of secondary investors who reside in the country of theobligor. Because local investors often are more comfortable withtheir local political, transfer, and/or convertibility risks than someonefrom another country may be, these secondary investors are morelikely to buy paper that originates locally. The importer may beable to get longer terms through forfaiting than with other formsof finance, because forfaiting transfers risk to secondary investorswho find the risk of a particular country attractive.

Example of Risk Transfer / Risk Management

Let’s examine a situation where Citibank satisfies a customer’sexport financing needs while maintaining an acceptable riskexposure.

Export Finance:Short term

Suppose a US supplier (exporter) has a US$15 million contract tosell products to a government-owned buyer in a developing countrywhose import regulations require that foreign suppliers grant 360-day terms. The US exporter, however, is unwilling to take the riskof possible non-payment of the resulting trade receivables.

Risk analysis In this situation there is the country risk associated with the overseasgovernment which may delay payment at maturity. There is also thecommercial risk that the buyer will default because the obligationsof the government-owned entity are not, in this situation, backed bythe full faith and credit of the country.

There are three ways that Citibank may satisfy the financing needsof the exporter.


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Option One

Assumption First, let’s assume that Citibank’s in-country branch is willing totake the commercial risk of the buyer but is unable to allocate cross-border (political) exposure for the full amount of the transaction.

Solution On behalf of Citibank’s customer (the exporter), Citibank obtainsan insurance policy from EXIMBANK to cover 90 to 95 percent ofthe country risk. (Depending on the country, the coverage may beless than 90% or it may be unavailable.) The remaining country riskexposure could be covered through a cross-border allocation, a tradefacility established through debt rescheduling, or recourse to theexporter. Retaining only an acceptable amount of risk, Citibank thenpurchases the discounted receivables from the exporter.

Option Two

Assumption Another option exists if the exporter is willing to grant a 360-daycredit to the buyer. The exporter may be willing to take all of thecommercial risk because s/he believes the buyer to be a reputablecorporation in its field and can earn a return on the financing thatjustifies taking the risks. The exporter, however, wants to avoidpolitical risk exposure for the full amount of the transaction.

Solution In this case, Citibank can arrange insurance coverage throughCitibank International Trade Indemnity (CITI) covering 95 percentof the country risk in the transaction. The exporter, however, mustretain the remaining 5 percent exposure. Notice that Citibank isproviding structuring rather than financing support and, as a result,this solution provides fee income without having to meet Returnon Assets (ROA) criteria.


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Option Three

Assumption /solution

Finally, let’s assume that EXIMBANK coverage is unavailable forthis country or tenor. CITI coverage may be available for 95% ofthe country risk, but the exporter wants to eliminate country andcommercial risks altogether. Citibank’s in-country branch iswilling to assume commercial risk for the entire transaction andhas cross-border capacity to cover the remaining five percent ofthe country risk.

You have been introduced to the types and goals of risk transfer.We conclude this section with a discussion of its advantages.

Advantages of Risk Transfer

Risk transfer provides three primary advantages to Citibank.

1. Increased market share and risk capacity

Example For example, Brazil’s cross-border limit in 1995 of $600 millionwas insufficient to meet the demand of Citibank customers whowanted protection from the country risks associated withBrazilian trade. Through risk transfer techniques such assyndication, Citibank was able to do twice the amount ofbusiness it could have transacted, given the $600 million limit. Inthis case, the total portfolio of Brazilian deals which Citibankoriginated in the first quarter of 1995 was $1.2 billion.

2. Building a positive image and reputation in a particular market

Example Syndications, especially silent syndications, allow Citibank toarrange very large transactions that bolster the Bank’s reputationand lead to other originations. An example is a very large capitalproject costing several hundred million dollars and lasting anumber of years. In such a case, Citibank transfers both thecountry and commercial risk in order to arrange deals where theamount of risk is beyond the capacity of any one bank.


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3. Leveraged returns

Example An example helps illustrate the advantage of leveraged returns.Kenyan risk is generally priced in the market at about 4% perannum. If Citibank keeps all of a deal involving Kenya, the Bankearns a 4% return on the country risk. By transferring some ofthe risk, the Bank earns 4% on the retained portion, managementand advisory fees, and the “skim” that represents the differencebetween the fees paid by the customer and the amount paid tothe syndicate members. The total revenue, as a is much greaterthan the 4% the Bank would have earned by booking the entireamount. (In order to earn the skim, the syndication must besilent, which is true of most deals.)

Risk transfer also helps Citibank reduce the assets carried on itsbalance sheet. Booking assets is not very attractive because it isdifficult to generate sufficient returns on those assets. (Expectedreturn on assets is discussed in Unit 5.)

SUMMARY

In this section, we defined credit risk and identified its sub-categories, lending risk (direct and contingent) and counterpartyrisk (presettlement and settlement), which are commonly associatedwith a trade transaction.

We also identified several other risks associated with tradetransactions. The more common risks fall under the category ofcountry risk which includes political (sovereign) and cross-border(transfer and convertibility) risks. Other risks to consider are image,product, operational / systems, legal and regulatory, documentation,and performance risks.


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Citibank assigns the Country Senior Credit Officer (CSCO) theresponsibility for evaluating country risk and establishing the cross-border allocation for that country. Through bank syndication,insurance policies, export credit agency guarantees, and forfaiting,Citibank transfers risk to other investors and, therefore, improves itsbalance sheet and market position relative to its risk limits.

You have completed the first section of Risk and Compliance. Please complete ProgressCheck 4.1, then continue with the next section on “Compliance Issues.” If you answerany questions incorrectly, please review the appropriate text.


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Question 1: Match each trade-related risk with its corresponding example.

a) Credit risk

b) Image risk

c) Performance risk

d) Political (sovereign) risk

e) Operational / systems risk

f) Documentation risk

g) Transfer risk

_____ In the process of granting a loan to a company, the Bank requests asignature on the promissory note. The person who signs the document isunauthorized by the company to do so and the note becomes unenforceable.

_____ A customer of the Bank develops financial difficulties and is unable torepay a loan from the Bank at the specified date.

_____ A potential customer requests financing for a project to develop a newtype of assault weapon.

_____ Telecommunications in the northeast part of the United States have beendisrupted, making it impossible to transfer funds electronically.

_____ The buyer’s country has experienced civil disturbances that affect thebuyer’s ability to meet his/her obligations to the Bank.

_____ A swimsuit manufacturer receives defective fabric from an overseassupplier and is unable to produce swimsuits in time for the summer season.

_____ Due to a shortage of dollars in the Egyptian central bank, an Egyptianimporter is unable to pay the US supplier in US dollars as specified bythe contract.


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ANSWER KEY

Question 1: Match each trade-related risk with its corresponding example.

a) Credit risk

b) Image risk

c) Performance risk

d) Political (sovereign) risk

e) Operational / systems risk

f) Documentation risk

g) Transfer risk

f In the process of granting a loan to a company, the Bank requests asignature on the promissory note. The person who signs the document isunauthorized by the company to do so and the note becomes unenforceable.

a A customer of the Bank develops financial difficulties and is unable torepay a loan from the Bank at the specified date.

b A potential customer requests financing for a project to develop a newtype of assault weapon.

e Telecommunications in the northeast part of the United States have beendisrupted, making it impossible to transfer funds electronically.

d The buyer’s country has experienced civil disturbances that affect thebuyer’s ability to meet his / her obligations to the Bank.

c A swimsuit manufacturer receives defective fabric from an overseassupplier and is unable to produce swimsuits in time for the summer season.

g Due to a shortage of dollars in the Egyptian central bank, an Egyptianimporter is unable to pay the US supplier in US dollars as specified bythe contract.


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Question 2: Citibank’s exposure to cross-border risk is managed by:

_____ a) the Head Office.

_____ b) each Country Senior Credit Officer in its branch network.

_____ c) product managers.

_____ d) the Society for Worldwide International Telecommunications.

Question 3: Investors willing to share the political risk of a Citibank syndication arehelping the bank reduce its exposure to:

_____ a) credit risk.

_____ b) regulatory risk.

_____ c) country risk.

_____ d) commercial risk.

Question 4: Guarantees are a risk transfer technique provided to Citibank by:

_____ a) export credit agencies.

_____ b) insurance companies.

_____ c) Citicorp International Trade Indemnity, Inc.

_____ d) Lloyds of London.


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ANSWER KEY

Question 2: Citibank’s exposure to cross-border risk is managed by:

b) each Country Senior Credit Officer in its branch network.

Question 3: Investors willing to share the political risk of a Citibank syndication arehelping the bank reduce its exposure to:

c) country risk.

Question 4: Guarantees are a risk transfer technique provided to Citibank by:

a) export credit agencies.


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Question 5: Place an X on the line in front of the types of credit risk.

_____ Political risk

_____ Direct lending risk

_____ Transfer risk

_____ Legal and regulatory risk

_____ Contingent lending risk

Question 6: The types of risks found in a trade transaction are defined below. Write therisk category beside its definition. Be as specific as possible and includesub-categories where appropriate.

__________ The actions of a government or independent events may affect the abilityof a customer of the Bank to meet his or her obligations to the Bank.

__________ The possibility that an activity of the Bank or one of its representativesmay damage the reputation of the Bank.

__________ One of the written instruments necessary for the trade transaction may beincomplete, incorrect, or unenforceable.

__________ The chance that a possible customer obligation will become an actualobligation and will not be settled on time.

__________ The probability that a country’s central bank will not allow a flow of fundsout of the country to complete the transaction.

__________ The risk that a transaction does not comply with all relevant regulations.


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ANSWER KEY

Question 5: Place an X on the line in front of the types of credit risk.

Political risk

X Direct lending risk

Transfer risk

Legal and regulatory risk

X Contingent lending risk

Question 6: The types of risks found in a trade transaction are defined below. Write therisk category beside its definition. Be as specific as possible and includesub-categories where appropriate.

Political The actions of a government or independent events may affect the (sovereign) ability of a customer of the Bank to meet his or her obligations to

the Bank.

Image The possibility that an activity of the Bank or one of its representativesmay damage the reputation of the Bank.

Documentation One of the written instruments necessary for the trade transaction may be incomplete, incorrect, or unenforceable.

Lending (contingent The chance that a possible customer obligation will become an actual lending) obligation and will not be settled on time.

Transfer The probability that a country’s central bank will not allow a flow of (cross-border) funds out of the country to complete the transaction.

Legal (regulatory) risk The risk that a transaction does not comply with all relevant regulations.


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Question 7: Place a T in front of the true statements and an F in front of the falsestatements.

_____ a) “Country risk” is the possibility that a borrower may not be able torepay a loan on time.

_____ b) “Lending risk” is a type of credit risk.

_____ c) “Product risk” is the risk that imported products may be defective.

_____ d) “Documentation risk” is the risk that documents required to completethe trade transaction are incorrect.

_____ e) “Country risk” includes political and transfer risk.

Question 8: Political risks are most significant in transactions between companies in:

_____ a) two developed countries.

_____ b) countries with freely convertible currencies.

_____ c) a developed and an emerging-market country.

_____ d) countries with local legal lending limits.

Question 9: The descriptions of two risk transfer techniques are found below. Writethe name of the risk transfer technique beside its description.

_______________ The risk of a transaction is split into several parts and sharedby investors willing to accept a portion of the risk in return fora portion of the fee.

_______________ Risk is transferred to overseas investors who purchase exporters’receivables without recourse.


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ANSWER KEY


F a) “Country risk” is the possibility that a borrower may not be able torepay a loan on time. (This is credit risk.)

T b) “Lending risk” is a type of credit risk.

F c) “Product risk” is the risk that imported products may be defective.(Product risk happens when the structure of a certain trade productis faulty or inadequate)

T d) “Documentation risk” is the risk that documents required to completethe trade transaction are incorrect.

T e) “Country risk” includes political and transfer risk.

Question 8: Political risks are most significant in transactions between companies in:

c) a developed and an emerging-market country.

Question 9: The descriptions of two risk transfer techniques are found below. Writethe name of the risk transfer technique beside its description.

Syndication The risk of a transaction is split into several parts and shared byinvestors willing to accept a portion of the risk in return for aportion of the fee.

Forfaiting (other investors) Risk is transferred to overseas investors who purchase exporters’

receivables without recourse.


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Question 10: Risk transfer enables Citibank to finance transactions that:

_____ a) do not conform to US legal requirements.

_____ b) do not meet the Bank’s credit criteria.

_____ c) cannot be sold in the forfait markets.

_____ d) exceed the total cross-border allocation for a particular country.

Question 11: Identify three parties that are able to provide insurance against politicalrisks associated with international trade transactions.

_____ a) Citicorp International Trade Indemnity, Inc. (CITI)

_____ b) Citibank, Nairobi

_____ c) Lloyds of London

_____ d) Export Import Bank of the United States (EXIMBANK)

_____ e) SWIFT

_____ f) Citibank, New York

Question 12: The purpose of Citibank’s cross-border risk allocation is to:

_____ a) limit the amount and type of international business that canbe done with any country.

_____ b) transfer a portion of the risk to other investors.

_____ c) ensure that the risk is acceptable in forfait markets.

_____ d) earn a portion of fees paid to syndicate banks.


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ANSWER KEY

Question 10: Risk transfer enables Citibank to finance transactions that:

d) exceed the total cross-border allocation for a particular country.

Question 11: Identify three parties that are able to provide insurance against politicalrisks associated with international trade transactions.

a) Citicorp International Trade Indemnity, Inc. (CITI)

c) Lloyds of London

d) Export Import Bank of the United States (EXIMBANK)

Question 12: The purpose of Citibank’s cross-border risk allocation is to:

a) limit the amount and type of international business that canbe done with any country.


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COMPLIANCE ISSUES

We mentioned earlier that one of the risks inherent in internationaltrade stems from the need to comply with legal and regulatoryrequirements.

Conformingto a rule ordemand

In general terms, compliance is the act of conforming to a rule ordemand. At Citibank, we must conform not only to high ethicalstandards, but to legal and regulatory obligations in the UnitedStates and other countries.

These rules and regulations include:

n Statutes and regulations adopted by a governmental regulatorybody

n Decrees and orders written by any court that has authorityover a Citicorp business or entity

n Ethical standards described in the Citicorp Policy Manual

Compliance issues in the trade business include US sanctions, USanti-boycott regulations, US export controls, and rules concerninganti-money laundering activities. (We examine each of these in thepages that follow.) Different Bank activities are concerned withdifferent compliance issues.

n In the Transaction Services area, specifically in Trade,Citibank employees need to know about US sanctions,US anti-boycott rules, US export controls, and rulesconcerning anti-money laundering activities.

n In the Cash Management area, an awareness of rulesconcerning anti-money laundering activities is required.


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Responsibilityof each Citibankemployee

Compliance is a personal responsibility. Each Citibank employee isheld accountable for all compliance-related activities; s/he must befamiliar with the rules, regulations, and ethical standards related tohis or her assignment. Each Citibank employee is provided with theappropriate level of compliance training specific to his/her jobassignment and must follow the requirements stated in his/hergroup’s compliance program.

Conflict oflaw issues

When a conflict of law issue occurs, it is important to analyze anddeal with it quickly. Accounts and assets located outside the UnitedStates are subject to local governmental laws and regulations. BothUS laws and local laws must be obeyed, but sometimes these twosets of laws conflict.

Example For example, when local laws permit (or require) normal trading andfinancial relations with countries (or individuals) that are subject toUS sanctions, conflicts of law occur. When such a controversy orconflict occurs, it is necessary to seek help from a supervisor. If theproblem cannot be resolved, the compliance officers and legalcounsel should be consulted. Remember, Citibank’s policy is tocomply with US law and local laws. If a conflict between US lawand local laws occurs, a satisfactory solution must be found.

Let us now look at four trade business compliance issues: sanctions,anti-boycott laws and regulations, export controls, and anti-moneylaundering laws and precautions.

US Sanctions

Blocking of agovernment’sassets

A sanction is an economic measure adopted by one or severalcountries to force a nation that is violating international law todiscontinue the offending behavior. Sanctions generally require afreeze or blocking of the sanctioned government’s assets. Trade withthe country is also prohibited. Sanctions may affect the followingtrade products: letters of credit, documentary collections, bankers’acceptances, and bank-to-bank reimbursements.


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The United States government occasionally adopts sanctions againstthe governments of certain countries — and sometimes against theircitizens. These sanctions are imposed under the authority of one ofthe following:

n Trading with the Enemy Act

n International Emergency Economic Powers Act

n United Nations Participation Act

Sanction Administration in the US

Sanctions are administered according to regulations issued by theUS Department of Treasury’s Office of Foreign Assets Control(OFAC).

OFAC lists The Office of Foreign Assets Control publishes extensive lists of“specially designated nationals” (SDNs) — persons or companiesconsidered to represent the governments of sanctioned countries.The OFAC also publishes a list of “specially designated terrorists”(SDTs) and of “specially designated narcotics traffickers” (SDNTs).

The assets of anyone included in any of the three lists – SDNs,SDTs, and SDNTs – also must be blocked, even if they are locatedoutside the “blocked” country. Because of the complexity of theseregulations, it is important to consult with your group’s counsel orthe Legal Affairs Office if a question arises concerning the assetsof blocked countries or of anyone included in any of the three lists.The Compliance Officer has a list of blocked countries as well asthe lists published by the OFAC on the SDNs, SDTs and SDNTs.

Blockingaccounts

Citibank must block accounts and assets if they:

n Belong to a blocked entity

n Are going to a blocked destination

n Are from a blocked destination


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When the blocked name is an existing customer of the Bank, theexisting accounts must be blocked. All documents (checks, bills oflading, etc.) must be seized and kept as blocked items. No trade maybe conducted until permission is obtained from the OFAC. Locallicenses do not satisfy US law.

If the blocked entity does not have an account with Citibank,a special “blocked” interest-bearing account must be created.These accounts cannot be debited without a license from the USgovernment. However, credits can and must be made. Citibankis not allowed to return funds to the remitter.

Reporting Requirements

All units maintaining blocked accounts or transactions must keepcomplete, up-to-date records. Reports must be submitted to theOFAC at specified intervals and sometimes on demand. Reportingis usually done by Group Counsels or by the Legal Affairs Office.

Penalties

Civil penalties of up to $250,000 may be imposed for violation orevasion of the regulations (for example, helping a customer avoidthe effect of the sanctions). If the violation or evasion is intentional,the maximum fine can be $1,000,000 and/or a prison term of up totwelve years. Severe violations may cause the loss of a franchise.

US Anti-Boycott Laws and Regulations

Request not todo business

A boycott is an explicit or implied request not to do business withcertain persons or companies in countries that are friendly to theUnited States. The most well-known example is the boycott ofIsrael by Arab and Islamic countries.

US companies are not allowed to comply with boycott requirementsthat have been imposed by governments, persons, or entities. TheExport Administration Act (EAA) of 1977 and the Tax ReformAct of 1976 prohibit this type of activity.


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The US anti-boycott laws and regulations apply particularly to tradesituations. However, they may apply to other situations, such as thehiring process, choosing business partners, or business opportunities.

Boycott request A Citibank subsidiary may receive a boycott request. If this situationoccurs, for example, in a clause of a letter of credit, Citibank shoulddecline to participate in the transaction unless the clause is removedor satisfactorily changed.


Citicorp’s participation, or request to participate, in a boycott mustbe reported directly to the Commerce Department. Under Section999 of the Internal Revenue Code, boycott requests also must bereported annually with Citicorp’s federal tax return.

Penalties

The Export Administration Act (EAA) imposes civil fines of up to$10,000 for each violation of US anti-boycott laws and regulations.Implementing and not reporting a boycott clause equals twoviolations. Criminal fines are up to $50,000 or, in the case of anexport transaction, five times the value of the exported goods and/orimprisonment for up to five years. In addition, export privileges orthe right to finance exports may be revoked or suspended. Violationof these laws may require the payment of a penalty — which maydamage the Bank’s reputation.

Discovering Noncompliance Issues

To discover noncompliance with anti-boycott policies, look for thefollowing in trade transaction-related contracts:

n Origin of manufactured goods


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n Blacklisted status of any party

n Eligibility of a carrier vessel to enter the ports of a countryor group of countries

n Prohibited shipments on certain vessels and limitations ontheir routes

n Business relationships with certain countries that requestparticipation in a boycott

Examples ofnoncomplianceclauses

For example, letters of credit may contain a clause certifying that thegoods are “not of Israeli origin” or that the vessel carrying the goods“will not stop at Israeli ports.” Citibank must go back to the bankthat issued the document and negotiate a deletion or change of theoffending clause. Citibank must report to the US government theoriginal clause that was believed to be a “request” to participate inthe boycott.

Another example is a clause requiring “provision of a certificatestating that the vessel carrying the goods is not blacklisted.”Citibank must go back to the issuing bank and request deletion ofthe clause. Because this type of clause is prohibited under both theExport Administration Act of 1977 and the Tax Reform Act of 1976,reports must be filed with the US Department of Commerce and theUS Department of Treasury.

The proper procedures for handling non-conforming situationsare explained in the Anti-Boycott Compliance Manual. You mayobtain this manual from the local anti-boycott compliance officer orfrom the Legal Affairs Office. Anti-boycott laws apply to Citibankbranches in the United States and overseas as well as Citicorp’sdomestic and international subsidiaries and affiliates.

We have examined the reporting requirements and penalties relatingto US sanctions and US anti-boycott laws. We will now look at thethird compliance issue, US export controls.


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US Export Controls

High technologyor strategicgoods

The export of high technology or strategic goods from the UnitedStates to other countries and/or the re-export of US technology fromone country to a third country are subject to US export controls forall countries. Citibank and its worldwide branches become involvedwhen they are asked to finance the production of goods or the exportof goods through a letter of credit.

Examples of high technology or strategic goods are computers,airplanes, arms-related technology, some chemicals, software, andencryption devices. Citibank has to be especially cautious when UStechnology is re-exported from Country X to Country Y.

The export control compliance process must include checking thelists of individual parties included in the following listings publishedby the US Department of Commerce:

n Missile Tech & Chemicals / Biological

n Debarred Parties

n Table of Denial List

Whenever the transactions contain names that appear on the lists,they must not be processed. The Trade Advisory Unit and theBusiness Unit Compliance Officer should be consulted for furtherguidance.

It is Citibank’s policy that the Credit Policy Committee must reviewand approve any transaction involving the shipment of militaryequipment, military parts, or armaments.


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Before exporting, the exporter must obtain a validated export licensefor high technology or strategic goods from either the USDepartment of Commerce Office of Export Administration (OEA) orthe US Department of State. Some licenses require reporting, but thisusuallyis the responsibility of the exporter and not of Citibank.

Penalties

Intentional violations carry a maximum penalty of five times thevalue of the export, or $1,000,000, whichever is greater, and prisonterms of up to ten years. An additional civil penalty includes thecancellation of export privileges which would prevent Citibank fromparticipating directly or indirectly in the export of strategic goodsfor which approval from the US Department of Commerce or theUS Department of State is required.

Anti-Money Laundering

Transfer fromillegal sourcesto legitimatechannels

Money laundering is a term used to describe the process ofconcealing the existence, illegal source, or illegal application ofincome. It is the investment or transfer of money flowing fromillegal sources into legitimate channels so that the original sourcescannot be traced. Banks and other financial institutions unwittinglymay be involved in the transfer, deposit, or investment of moneythat comes from illegal activity. Trade products that unintentionallymay facilitate money laundering activities include letters of credit,documentary collections, bankers’ acceptances, and back-to-backreimbursements.

The Money Laundering Process

There are three independent activities in the money launderingprocess.


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n Placement is the physical action of placing bulk cashproceeds.

n Layering separates the proceeds of criminal activity fromtheir origins through layers of complex financial transactions.

n Integration is the act of providing what appears to be alegitimate explanation for the illicit proceeds.

A successful money laundering operation will assure that no “papertrail” connects these three events.


The US government has passed two laws that create currencyreporting obligations: the Bank Secrecy Act (BSA) and the MoneyLaundering Control Act (MLCA).


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BankSecrecy Act

The Bank Secrecy Act requires banks to file reports and keeprecords for five years on matters that are useful in investigationsof criminal, tax, and regulatory violations. An amendment to thisact grants a bank regulator the right to revoke a US bank’s charter,license, and/or deposit insurance if convicted of money launderingcrimes.

An important BSA report is the Currency Transaction Report(CTR). Citicorp and all of its entities in the United States must filea CTR with the Internal Revenue Service for every cash deposit orwithdrawal over $10,000. Citicorp has established a global policythat requires the monitoring of large cash transactions. Outside ofthe United States, Citicorp recognizes local law requirements forreporting cash transactions to local authorities.

MoneyLaunderingControl Act

The Money Laundering Control Act makes money laundering afederal crime and defines the criminal offenses that are part ofthe money laundering process. A criminal offense occurs when aperson knowingly conducts, or attempts to conduct, transactionsusing funds derived from illegal activities. The MLCA applies toUS citizens and enterprises acting outside US borders, such asCiticorp and Citibank, N.A.

“Know-your-customer” policy

The “know-your-customer” policy is an important part of theanti-money laundering program. It requires financial institutionsto monitor new and existing accounts to help identify suspiciousactivities conducted by their customers.

Avoiding Problems

In order for Citibank to avoid being used to launder money, weshould:

n Determine the true identity of all customers that requestthe Bank’s products and services


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n Identify customers that seek to conduct significantbusiness transactions as well as those customers usingsafe-custody facilities

n Establish transaction profiles for each customer to helppredict the types of transactions that are consistent withthe customer’s profile

To avoid problems, it is important to be updated continually onUS sanctions and US anti-boycott regulations and to know thecustomer and his/her business plans. The compliance proceduresfor Latin America, the Middle East, and Africa require a BasicInformation Report (BIR) for all new account openings, regardlessof whether or not the customer is from a high-risk company.

UNIT SUMMARY

At the beginning of Unit 4, we discussed the risks that have thegreatest effect on trade transactions. We described the process usedby Citibank to assess and manage country (political and cross-border) risk. Based on a risk assessment, the control unit for eachcountry establishes a limit on the amount and type of cross-borderbusiness Citibank is able to do with that particular country. Toexceed its self-imposed limits, Citibank uses a variety of risk transfertechniques that increase its risk capacity. These include syndicationof risk to other banks, insurance policies, guarantees or insurancearranged through export credit agencies, and the sale of risk to third-party investors through the forfait market.

We identified two agencies that provide insurance for tradetransactions: CITI and Lloyds of London. Trade credit insuranceand country risk insurance were discussed. Not only do you needto recognize the different types of risk associated with internationaltrade, you also must be aware of the types of insurance that havebeen developed to reduce those risks.


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We learned about Citibank’s obligation to conform to the laws andregulations of the United States and other countries. It is Citibank’spolicy to comply with both US laws and local laws. When conflictsoccur, a satisfactory solution should be found that maintainsCitibank’s integrity locally and in the United States. In the event thatwe cannot reach a satisfactory solution, Citibank will always complywith US laws. Supervisors, compliance officers, and legal counselare available to offer the trade officer any assistance necessary toresolve compliance issues.

The trade officer must understand US anti-boycott laws, USsanctions, and US export controls because they affect the flow ofgoods and services in the global marketplace. If these regulations andtheir reporting requirements are not properly followed, seriouspenalties may result.

We discussed the money-laundering process and reportingrequirements. In order to avoid involving Citibank in moneylaundering activities, the trade officer must know the customer’sbusiness.

You have completed Unit 4, Risk and Compliance. Please complete Progress Check 4.2to test your understanding of the concepts and check your answers with the Answer Key. If you answer any question incorrectly, please reread the corresponding text to clarifyyour understanding. Then, continue to the final unit of this workbook, IdentifyingCustomers’ Needs and Pricing Solutions.


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Directions: Determine the correct answer(s) to each question. Check your answers withthe Answer Key on the next page.

Question 1: Place an X in front of four obligations with which Citibank must comply.

_____ a) Boycott requirements that have been imposed by a foreign government

_____ b) Trade boycott against Israel by Arab and Islamic countries

_____ c) Economic measures against a country that is violating international law

_____ d) Rules regarding placement, layering, and integration of cash proceeds

_____ e) Guidelines of the Trade Advisory Unit

_____ f) US government prohibition of boycott participation

_____ g) US Export Controls

Question 2: A boycott is:

_____ a) an economic measure adopted by the United States to block the assetsof a country’s government.

_____ b) an explicit or implied request not to do business with certain personsor companies.

_____ c) a specific category of regulations developed to protect the domesticmarket from foreign competition.

_____ d) a quantitative restriction on the import of an article into the UnitedStates.


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ANSWER KEY

Question 1: Place an X in front of four obligations with which Citibank must comply.

c) Economic measures against a country that is violatinginternational law

d) Rules regarding placement, layering, and integration ofcash proceeds

f) US government prohibition of boycott participation

g) US Export Controls

Question 2: A boycott is:

b) an explicit or implied request not to do business with certain personsor companies.


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Question 3: When Citibank blocks the account of a specially-designated national, it iscomplying with:

_____ a) US sanctions.

_____ b) US anti-boycott laws.

_____ c) US export controls.

_____ d) the Bank Secrecy Act.

Question 4: The trade officer must know which products are considered “strategic” bythe US government in order to comply with:

_____ a) US sanctions.

_____ b) US anti-boycott laws.

_____ c) US export controls.

_____ d) the Bank Secrecy Act.


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ANSWER KEY

Question 3: When Citibank blocks the account of a specially-designated national, it iscomplying with:

a) US sanctions.

Question 4: The trade officer must know which products are considered “strategic”by the US government in order to comply with:

c) US export controls.


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Question 5: A license to export strategic or high technology must be obtained from the:

_____ a) US Department of Transportation.

_____ b) Interstate Commerce Commission.

_____ c) Securities Exchange Commission.

_____ d) US Department of Commerce.

Question 6: The blocking of a government’s assets is an economic measure that isintended to:

_____ a) influence the behavior of a government that performs illegal actsaccording to international law.

_____ b) create a balance of trade between two nations.

_____ c) correct the illegal behavior of citizens in countries that are officialenemies of the US.

_____ d) force an alteration of that government’s trade policies.

Question 7: Which two laws create currency reporting obligations?

_____ a) International Emergency Economic Powers Act

_____ b) Bank Secrecy Act

_____ c) Money Laundering Control Act

_____ d) US Criminal Code


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ANSWER KEY

Question 5: A license to export strategic or high technology must be obtained from the:

d) US Department of Commerce.

Question 6: The blocking of a government’s assets is an economic measure that isintended to:

a) influence the behavior of a government that performs illegal actsaccording to international law.

Question 7: Which two laws create currency reporting obligations?

b) Bank Secrecy Act

c) Money Laundering Control Act


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Question 8: The “know your customer” policy is a requirement of which complianceissue?

_____ a) US export controls

_____ b) US anti-boycott

_____ c) Anti-money laundering

_____ d) US sanctions

Question 9: One requirement of the Bank Secrecy Act is:

_____ a) a report on all transactions with customers outside the US.

_____ b identification of the true identity of all customers that request theBank’s products and services.

_____ c) a CTR filed with the IRS for every cash deposit / withdrawal over$10,000.

_____ d) a “paper trail” to connect the three events of the money launderingprocess.

Question 10: An opening bank in Russia issues a letter of credit with 100% cashcollateral for confirmation from Citibank, NY. After receipt of theconfirmed letter of credit, the beneficiary requests that Citibank, NYcancel the letter of credit. As a result, Citibank, NY must return thecash collateral to the opening bank in Russia. However, the openingbank instructs Citibank, NY to transfer the funds to a third party locatedin Cuba. What compliance issues may arise from the opening bank’snew instructions?

_____ a) Anti-money laundering

_____ b) US anti-boycott

_____ c) US export control

_____ d) US sanction


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ANSWER KEY

Question 8: The “know your customer” policy is a requirement of which complianceissue?

c) Anti-money laundering

Question 9: One requirement of the Bank Secrecy Act is:

c) a CTR filed with the IRS for every cash deposit / withdrawalover $10,000.

Question 10: An opening bank in Russia issues a letter of credit with 100% cashcollateral for confirmation from Citibank, NY. After receipt of theconfirmed letter of credit, the beneficiary requests that Citibank, NYcancel the letter of credit. As a result, Citibank, NY must return thecash collateral to the opening bank in Russia. However, the openingbank instructs Citibank, NY to transfer the funds to a third party locatedin Cuba. What compliance issues may arise from the opening bank’snew instructions?

a) Anti-money laundering

d) US sanction

Unit 5

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UNIT 5: IDENTIFYING CUSTOMERS’ NEEDSAND PRICING SOLUTIONS

INTRODUCTION

Your understanding of the trade environment, trade services and finance, and their relatedrisk and compliance issues will enable you to identify and develop new trade-relatedbusiness for Citibank. In this final unit, we describe the information-gathering processthat helps identify a prospective or current customer’s trade-related banking needs. Inaddition, we explain key pricing benchmarks and provide guidelines for pricing a product.We conclude with a discussion of the procedure for submitting a proposal to a customer.

This unit contains a large amount of reference material that will be useful in the future.Keep that in mind as you read through the unit. Feel free to duplicate certain sections foruse as quick references.

UNIT OBJECTIVES

After completing Unit 5, you will be able to:

n Recognize questions that are used to identify customers’ needs

n Identify benchmarks that apply to pricing

n Recognize guidelines used when pricing solutions

n Recognize the structure of offering letters

5-2 IDENTIFYING CUSTOMERS’ NEEDS AND PRICING SOLUTIONS

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THE INFORMATION GATHERING PROCESS

When a customer approaches Citibank with a business deal oropportunity, we want to obtain sufficient information about thecustomer’s business to determine his/her needs. This information,combined with knowledge of the trade environment and tradeservices, enables us to develop a solution that will meet ourcustomer’s needs. In the process, we are able to create new businessopportunities for Citibank.

Existing Customers

Information incustomer’s file

If the customer currently does business with Citibank, someinformation already may be in the customer’s file. For example, ifthe customer buys raw materials or products on a regular basis frominternational suppliers and sells to international buyers, the Bankshould have a list of these suppliers and buyers. The file also shouldindicate the total volume of imports and exports as well as thepayment options used for settling international trade transactions.

Other internalsources ofinformation

In addition, you may obtain information from the following internalsources:

n Trade reports, available from the trade product manager

n Country trade reports on imports and exports, usuallykept by product managers

n Industry analysis and research undertaken by the creditarea with the objective of analyzing credit information

IDENTIFYING CUSTOMERS’ NEEDS AND PRICING SOLUTIONS 5-3

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n Information on the customer’s business revenues(documented in the customer’s Basic Information Report[BIR] which Citibank prepares for each customer) andproduct / customer revenues (available through variousreports, such as the product and account profitabilityreports, generated by Financial Control – FINCON)

n Statistics on trade volumes, provided by the customerand kept by the Relationship Manager or the ProductManager

n Pricing pattern for the customer — examine previousCredit Approvals (CAs) which contain all terms andconditions of credit proposals

n Balance sheet (e.g. Does the customer have debt? Ifyes, what is the amount? Is it in US dollars? What isthe maturity date?)

n Previous call plans and call reports

You should talk to the Relationship Manager and Product Specialistswho presently work with the account as well as to those who hadbeen previously assigned to the account. They are important sourcesof information because they can relate past experiences with thatcustomer to reinforce any written information.

New Customers

When the relationship with the customer is new, the RelationshipManager and the Product Manager’s focus in the first meeting isto assess the customer’s trade business. (Prior to any meeting, youshould prepare a detailed call plan based on your information-gathering research so that you can demonstrate your knowledgeof the customer’s business.)


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In the first meeting, ask questions to gather current facts andbackground information. You also should explore any problems,difficulties, and dissatisfactions the customer may have experiencedin order to identify areas where Citibank services can help.

To understand the customer’s business, you must gather informationabout his/her product(s), clients and suppliers and their possiblefinancing needs, the customer’s own financing needs, and currenttrade practices. Try to identify any extraordinary risks as well ascustomer service issues that may provide opportunities to satisfyhis/her needs and build the relationship. The following sets ofquestions will help facilitate this information-gathering process.

Customer’sproduct mix

The questions below help you obtain information about thecustomer’s product(s).

n What is the customer’s product offering? Is there a singlebasic product? Are there other related products?

n Is all of the customer’s production sold locally? If the answeris “yes,” the customer is not exporting. Otherwise, proceedwith the next question.

n What is the customer’s sales mix between local andinternational buyers? What is the product mix of the exports?

n What percentage of sales over the last two years weredomestic? What percentage were exports? What will theproduct mix be for the next year? For the next two years?Will it grow, decline, or remain stable?

The information provided by these questions will help determine ifthe customer is taking advantage of a temporary market opportunityor is committed to foreign trade. This information is important forpricing our solutions. Customers committed to foreign trade are moreprice sensitive and efficient since they must compete in the globalmarketplace.


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Customer’sclient (buyer)

The second series of questions concentrates on our customer’sclient and its relationship with Citibank. This information is usedto identify new business opportunities for Citibank with ourcustomer’s client.

n Who are the customer’s principal clients (buyers) abroad?

n Does the customer know if these buyers are Citibankcustomers?

n Would the customer object if Citibank investigated thepossibility of meeting the needs of both parties?

Financing needsof the customer’sclient

The third set of questions focuses on business opportunities relativeto the financing needs of the customer’s client.

n Is the customer offering financing terms to his/her buyers? Ifthe answer is “yes,” to what buyers and under which terms?

n Would it be beneficial to the customer to offer an extensionof current financing terms as part of the sales approach tothe buyer?

n Which financing terms would the customer expect to offer(e.g., tenor, price)?

n Would the customer offer financing terms to all of itsbuyers or only to some of them? Who are they and in whichcountries are they located? How would the customer planto obtain the financing (letter of credit)?

n If the buyer’s risk is unacceptable to Citibank, is the customerprepared to accept the discount with recourse? This meansthat if the buyer does not pay, Citibank’s customer will beliable for payment at maturity.


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Customer’ssuppliers

The next set of questions focuses on the customer’s suppliers.

n Does the customer purchase all supplies in the country?If the answer is “yes,” proceed to the question below.Otherwise, move to the next bulleted question.

When the customer purchases supplies locally, are thesupplies manufactured locally, or are they imported andthen purchased from local representatives?

• If the answer to either of these questions is “yes,” hasthe customer considered importing supplies directly?

• If the customer does not import directly because ofpolicy decisions or other technicalities, are there plansto make changes? If there are, record this informationfor follow-up during the next visit.

• If the customer does not import directly because ofpurchasing terms, what payment terms will encouragehim or her to consider direct imports?

n Who are the customer’s largest suppliers? Be sure to getthis information for each product.

n In what countries are the suppliers located?

n Do the suppliers provide financing terms? Do the termsmeet this customer’s needs?

n Are the offshore suppliers also Citibank’s customers? If theanswer is “no,” ask if the customer objects to the bank’sinvestigating the possibility of serving the needs of bothparties.

Other financialneeds

So far, we have questions for collecting information on ourcustomer’s products, the customer’s client and possible financingopportunities, and the customer’s suppliers and possible financingopportunities. The purpose of the next two questions is to identifyany other financial needs of the customer.


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n Does the customer need additional financing? If the answeris “no,” investigate the supplier’s financing costs. Citibankmay be able to offer better financing.

n Which tenor is the customer seeking? If the tenor isacceptable to the customer, investigate the amount needed,payment schedule, etc.

Customer’scurrent tradepractices

At this point, the Relationship Manager and/or Product Managershould know about the customer’s buying and selling processes,any offshore suppliers, and its financing terms. The next series ofquestions focuses on the customer’s current trade practices.

n How many banks are involved in processing the customer’strade transactions and trade financings?

n How does the customer pay for imports? Are there anyoffshore Demand Deposit Accounts (DDAs)?

n Does the customer collect the payments for the exportslocally and/or through an offshore DDA (e.g., NY, London)?

n Does the customer operate on open account, documentarycollections, or letters of credit basis?

n In terms of documentary collections and letters of credit,do we have information on:

• Total annual volume?

• Number of trade transactions?

• Local banks used?

• Export credits the customer may be receiving (findout from where, which banks are involved, and thepayment terms)?

• Pricing (including fees and minimum commission)? Extraordinaryrisks

The purpose of the next question is to identify any extraordinaryrisks that might affect the Bank.


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n Does the customer plan any business expansion or newinvestments that may raise medium-term financing forcapital goods?

Customerservice

The final questions focus on customer service, which is alwayspart of our ongoing efforts in assessing our customer’s needs.

n What are some of the trade-related needs that the customerfeels are not being properly serviced or that could beimproved?

n Is the customer satisfied with the way we provide services?Are we fulfilling our customer’s expectations in terms oftimely and accurate services?

n Is there any other information the customer could providethat would enable us to improve our services and addvalue to our customer relationship?

Once the information-gathering process is completed, the next stepis to structure a solution that meets the customer’s needs and alsois profitable for the Bank. The structure of the solution is based onCitibank’s product offerings.

KEY PRICING BENCHMARKS

Basic benchmarks that the Bank defines for a country and/or aregion, plus data from the market, must be considered in pricing thesolution that has been structured for the customer. These benchmarksinclude:

n Minimum return on cross-border risk

n Expected return on assets

n Revenue to expense ratio

n Market quotations for similar risks


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Minimum Return on Cross-Border Risk

The movement of funds across borders introduces potentialdifficulties in terms of currency management, exchange regulations,taxation, and timing. Restrictions on moving funds out of a countrymay occur as the result of economic problems, political instability,or sovereign actions within the country. Citibank must assess thesize of cross-border risk (transfer and convertibility risks) associatedwith each transaction and the amount the Bank needs to make on atransaction in order to obtain a return on the risk.

Example:Size of cross-border risk

For example, in a pre-export financing, the seller (exporter) has afirm contract of sale and needs financing to acquire and preparegoods for shipment. The seller obtains a loan from the bank in theimporter’s country to prepare and ship the goods to the importer.The importer will now have to repay the loan directly to the lendingbank in its country. This financing has a lower cross-border riskbecause the proceeds from the importer are applied locally for therepayment of the loan.

Consider now an import financing, where the buyer (importer) ispurchasing goods under a sight letter of credit and needs financingto meet the required payment under the credit. There is a highercross-border risk because local funds must be converted into hardcurrency and transferred offshore in repayment. These differencesare reflected in the size of the margin and the sublimits for thedifferent types of transactions.

Remember, Citibank in each country / region is assigned a cross-border limit on the amount of funds that may carry cross-border risk.Within each overall limit are sublimits for each type of product andtenor. For instance, the cross-border trade limit for Brazil may be$200MM, with $150MM designated for short-term trade (e.g.$100MM for pre-export financing and $50MM for import financing)and $50MM allocated to medium-term trade (e.g. $40MM for pre-export financing for up to two years and $10MM for importfinancing between 2 and 3 years).


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Expected Return on Assets

Measure useof assets togenerateearnings

The second factor to consider in pricing is the expected return onassets. This is the total shareholder equity calculated as a percentageof total assets. The return on assets ratio measures the Bank’sperformance in using assets to generate earnings. Banking laws inall countries require a minimum assets-to-capital ratio.

The ratio is affected when assets are booked at a very low margin.Citibank may be required to increase capital before it can bookadditional assets when revenues do not increase the net worth inproportion with the growing assets.

At the corporate level, the expected return on assets is implied inthe budget through the expected level of assets. At the countrylevel, the expected return on assets is implied through a minimumreturn. Balance sheet ratios indicate the wealth of a company. It isimportant for Citibank to keep a healthy return on assets ratio toremain attractive to shareholders and investors.

Revenue-to-Expense Ratio

Expensesincurred toproducerevenues

The revenue-to-expense ratio is another factor in pricing a product.Externally, the Bank’s efficiency is measured by rapid and low-costsatisfaction of customer needs. Internally, efficiency is measured bythe amount of expenses incurred to produce a predefined level ofrevenues.

Example For example, Citibank is trying to achieve a net revenue-to-expenseratio of 4:1 (four dollars in revenues for each dollar spent). This netfigure represents a complex mix of products which includes labor-intensive products such as trade transactions. The ratio for tradeproducts usually does not exceed 1.5:1 (one and a half dollars infees for each dollar in expenses). The less labor intensive products,such as capital markets, can achieve a 10:1 ratio. When determiningprice, it is important to consider all the processing that is required tosupport a product.


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Market Quotations for Similar Risks

Monitorcurrent marketconditions

Citibank’s involvement in local markets requires constantmonitoring of current market conditions, which are used as abenchmark to review, update, and optimize the Bank’s pricing.

Example For example, Citibank may decide that the minimum return on cross-border risk is 4% per annum and that the Bank must charge a fee ofat least $2,000 for an import letter of credit to maintain anacceptable revenue-to-expense ratio. If the market moves to a 3%per annum spread and a $500 fee, the Bank can either lower itsprices or risk losing the business.

An alternative may be to improve the pricing by reducing thecosts associated with fees. This alternative involves a higher levelpolicy decision, possibly requiring a change in market strategyfollowed by a strong, clear, accurate action plan.

At this stage, the product is defined and key benchmarks of pricingare analyzed. Now, you must determine the right price to quote tothe customer.

PRICING GUIDELINES

Risk Identification

In simple terms, pricing is the placement of a dollar value on therisks involved in a transaction. It is necessary to identify andquantify the different risks associated with a transaction in orderto determine the price.

Questions thatidentify risk

The following questions will help to identify the risks:

n Is country risk involved?

n Is credit (commercial) risk involved?


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n Is a third-party risk involved?(e.g., the confirmation of an export letter of credit)

n Is this a one-time quotation?(e.g., a pre-export financing to be disbursed thefollowing week)

n Is the risk extended over a period of time?(e.g., a quotation of $40MM of pre-export financingto be disbursed within the next seven months)

The time element is particularly important in emerging economiesdue to the high volatility of market prices. If the Bank sets the pricetoo low and market prices increase, the Bank may lose money. If theprice is too high, the customer may take his/her business elsewhere.

If volatility is high or the spread (interest increment charged overLIBOR) is expected to increase, the quotation may be given withthe condition that the rate may be adjusted if market rates go over“X”% of the quotation. Both parties would have to negotiate therate adjustment.

General Guidelines

Key pointsto consider

Use the following guidelines as a reference for pricing. Theyinclude the key points to be considered for the most commonlyused transactions.

Documentary Collections, Transfers, and PaymentOrders

For documentary collections, funds transfers, and payment orders:

n Quote a flat fee (e.g., $15 or $20 for a funds transfer) formultiple, low-value operations. The fee works as a minimumcommission but, from a sales point of view, it is easier toexplain to the customer.


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n Quote a commission (e.g., 0.1%) with a minimum (e.g.,$80 per item) when the value per transaction and numberof transactions is unknown, or very large, or when thecustomer has a large volume of transactions with a widerange of values.

When pricing the minimum commission, consider internalcosts (e.g., cost of handling the documentary collections, costof funds transfer, cost of payment order) which vary andfluctuate from country to country. The Product Manager ineach country has this information.

n Use innovative pricing models, such as the globalcommission, when the Bank knows the customer’sbusiness very well.

n Consider how much the customer currently is paying forthis product.


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Import Letters of Credit

For import letters of credit, the following considerations should beaddressed:

n ALADI — Does the letter of credit involve sovereignexposure or is it an ALADI letter of credit? For ALADI thereis no cross-border risk since it is equivalent to a letter ofcredit with local currency. The seller is paid in its country’slocal currency and the buyer pays in its country’s localcurrency.

n “All-in” Quote — The “all-in” quote includes correspondentbank charges. It is important to know the fees charged by thecorrespondent banks since more customers are requestingthis type of quote.

n Global Finance MIS — This reporting allows the capture ofall customer-related revenues at a local level, irrespective ofthe country from which it is collected, as well as thecorporation as a whole.

For an import letter of credit, the local branch, as the issuingbank, charges for the commercial and country risks whichare implicit in the transaction. Additionally, Citibank abroadreceives advising, confirmation, and export credit negotiationfees. As a result, the country’s local branch trade businessunit will be looking at the offshore revenue as “customerrevenue” not collected locally. This revenue assignmentshould not be used to reduce the fees collected from theimporter for the risks Citibank is assuming locally.

n Out-of-pocket expenses — Who is going to pay the out-of-pocket expenses (e.g., telexes, faxes, couriers, postage)? Arethey included in the pricing? If these expenses are included,the customer should be notified that the quotation is freeand clear of any further charges. If these expenses are notincluded in the quotation, the customer should be informedthat s/he will be charged for them.


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n “Flat fee” or per annum (p.a.) — The price for opening animport letter of credit can be quoted either as a flat fee or ona per annum basis. In the case of a flat fee, the customer willpay a fixed percentage, e.g. 3%, of the total amount of theletter of credit independent of its tenor. The correspondentbank’s expenses may, or may not, be quoted as part of thisfixed fee structure. For instance, a bank that opens an importletter of credit in the amount of $100M may charge a flatfee of 3%, but does not include the correspondent bank’sexpenses. The issuing bank’s charge to the applicant wouldbe $100M 5 0.03 = $3M.

If we quote on a per annum basis, the calculation of thecharge will be based on the amount, spread, and tenor of thetransaction. For instance, if a bank charges 3% per annumfor a letter of credit for $100,000, and the validity period is90 days plus 180 days of deferred payment, the total tenorfor this transaction will be 270 days.

The calculation of the charge for this transaction will be(100,000 5 0.03 5 270) / 360 = 2,250.

The correspondent bank’s charges may be treatedindependently unless we have some kind of agreement onthe cost to be charged by them.

Export Letters of Credit

When pricing export letters of credit, use the following guidelines:

n Advise and negotiation — If the credit is a large one withmultiple shipments and/or negotiations, the bank shouldclearly state the number of negotiations included in thequotation and the pricing for each additional negotiation.


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n Confirmation fees — It is important to know the bankand the location of the confirming bank. There could bea different quotation when a letter of credit is issued bya different branch. The product managers can provideassistance with this type of situation.

n Transferable L/C — The fee for a transferable letter ofcredit should be indicated, even if it is a nominal fee.

n “All in” for the importer — When the opening branchrequests a quotation, items included in the quotation shouldbe stated. Charges, if any, that are to be collected separatelyor based on volume (such as the negotiations) should alsobe priced.

Trade Finance

In the trade finance area, the following information will help todetermine pricing.

n When LIBOR? — LIBOR is quoted when the tenor is fixed(e.g. import financing). Prepayment of transactions priced onLIBOR incurs a penalty fee plus the LIBOR differential forthe remaining period (charged by the treasury).

We further explain this in the example that follows.


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Example For instance, suppose a customer obtains $100M of import financingfor 180 days at 7.75% p.a. (LIBOR 5.75% p.a. plus a spread of 2.0%p.a.). As a result, the bank’s treasury borrows funds from the moneymarket at 5.75% p.a. interest rate for 180 days. However, if thecustomer decides to prepay the loan in 90 days, s/he may face twoopposing scenarios. If LIBOR for the remaining 90 days of the loanis lower, i.e. 5.25% p.a., the treasury stands to lose 0.5% p.a. (5.75%p.a. – 5.25% p.a.) since it borrowed at a higher rate from the localmoney market and now the market is offering a lower rate. TheLIBOR differential of 0.5% p.a. will have to be charged back to thecustomer: (100M 5 90 5 0.005) / 360 = $1.25M. On the other hand,if LIBOR for the remaining 90 daysis the same (e.g. 5.75% p.a.) or higher, the treasury gains from thetransaction and will not charge any LIBOR differential to thecustomer.

n When Prime? — The prime rate is quoted when therepayment is tied to an event where the date cannot bespecifically determined — for example, a pre-exportfinancing. Revenue comes from the difference between thepool rate (equivalent to LIBOR) and the prime plus spread.The prime rate changes on a daily basis and may be loweror higher than LIBOR.

n Guarantees and collateral — The risk of guarantees andthe value of collateral must be considered in the pricing.

n Market rates — How do Citibank’s rates compare tocurrent market rates?

n Innovation — The customer’s business should be reviewedwith the Product Manager to uncover tax advantages. Taxsavings to the customer may improve the bank’s price. Beinnovative!

n Floating and fixed rates — Part of the period maybe quoted based on a fixed rate (e.g. LIBOR) and theremainder of the period based on the equivalent primerate (floating rate).


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Example Suppose a customer requests a 180-day pre-export financing inwhich the total rate for 150 days is 7% p.a. (LIBOR 4% p.a. plus 3%spread) and the remaining 30 days at prime* (6.5% p.a.) plus 1%spread. During the first 150 days, the customer pays a fixed rateof 7% p.a. of the amount of the loan. For the remaining 30 days, thecustomer pays a floating rate since the prime varies on a day-to-day basis. On Day 1 of the 30 days, the prime rate is 6.5% p.a., buton Day 2 it could be 7% p.a., Day 3 7.15% p.a., and so on. If theprime rate ends higher at the end of the 30 days, the customer paysmore for the loan than the initial rate quoted for the first 150 days.

* In this case, the prime is 6.0% p.a., not 6.5% p.a. — or the spread is 0.5% p.a. You must have the sametotal rate of 7.00% p.a.

The idea is that when you price to the customer, you prepare the quotation based on current rates and thedifferential; i.e.:

Day 1: LIBOR = 4.00% p.a., Prime = 6.50% p.a., and Spread = 3.00% p.a.

You will quote LIBOR plus spread: 4 + 3 = 7.00% p.a. for the first 150 days

For prime, we also have to achieve the 7.00% p.a.; so, the loan will be booked at prime plus spread:6.5% p.a. + 0.50% p.a. = 7.00% p.a.

Both the customer and the bank run the risk of prime’s variation. If the prime goes up, the customer paysmore than expected for the loan; if the prime goes down, the bank gets less than expected.

n Bundled with transactions — For example, an attractiveL/C fee may be quoted if subsequent financing is to beprovided by the Bank. Take into account the aggregatewhen more than one product is involved.

Selling Trade Paper

When selling trade papers (e.g. drafts, banker’s acceptance), it isimportant to consider the following:

n Participations — The percentage of the Bank’s participation,as well as the risks involved (country and/or commercial),should be stated.

n Forfaiting — The quotation for selling the paper is what theBank will receive for the period accrued as of the date of sale.


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n Selling Export Credit Agencies (ECAs) — The market pricevaries if a full comprehensive guarantee has been obtained.The structured trade finance coordinator can guide the tradeofficer through the process. Usually the paper is sold by theUnited States or European distribution teams at Citibank whoare more acquainted with the market.

PRESENTING THE OFFER TO THE CUSTOMER

Once you have structured and priced the solution, you are ready topresent the proposal to the customer. In this section, we examine theformat and content of the initial letter sent to the customer — calledan “indicative offer.” It is an explanation of the Bank’s proposaland not a commitment to provide financing. The indicative offer issometimes confirmed by a second letter, the “firm offer.”

Format of theinitial letter

To begin, it is important to use the correct stationery with the mostrecent letterhead. The language should be direct and concise. Everynumber must be checked to ensure that it is correct. All of theconditions must be stated in the letter. Copies should be madeand distributed to all persons involved in the implementation anddelivery of the proposal.

Here is an explanation of the contents of the indicative offer letterthat can be found in the sample in Figure 5.1. A sample of a firmoffer may be seen in Figure 5.3.

Format of theindicative letter

Heading — The heading of the offering letter should includethe date and the department from which the offer originates.If the letterhead is printed, only the date is required.

Addressee — The offering letter must be addressed to thecorrect person and department in the company to which theoffer is being made. If necessary, copies may be made for otherdepartments or persons involved in the transaction.


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Situation — A brief description of the situation should be inthe letter. For example, “During our meeting last Monday, wediscussed your need to export a certain amount of . . .”

Proposal statement — It is important to state that the letter isa proposal. It will be effective and binding whenever signedand agreed to by the customer or an authorized person from theBank.

Terms and conditions — The letter must state precise details onthe terms and conditions of the offer, such as tenor, pricing, andlegal vehicles involved. The price must include the costs, thebase rate for computing the interest, whether or not an advancepayment is required, and any other issues that relate to the priceand cost of the offering. This information may be included in thebody of the letter or in the Annex to the letter (see Figures 5.2and 5.4).

Acceptance procedure — The letter must explain the procedurefor accepting the offer, important deadlines or milestones,documents required, etc.

Signature — The offering letter must be signed by theRelationship Manager or Product Manager. (Send a copy tothe Manager that did not sign the letter.)


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January 20, 1999

(Name and Title)Tractores ButterflyAddressCity, State ZIP

Dear Mr. or Ms.:

At our last meeting, January 15, 1999, you stated that you were looking for an adequatealternative of funding for your production of farm tractors for export. Your monthlyproduction is 30 farm tractors for the local market and 40 for export.

We discussed alternatives to the financing of raw materials for the production of 40farm tractors. At this time, we would like to present a feasible option. Considering yourrequirements, we think the most suitable product for your company is pre-export financing.

The enclosed terms and conditions are presented on an indicative basis only and aresubject to our own internal credit approvals and the current market situation at the timeof the contemplated financing. This proposal is not a commitment to provide financing.It is an indication of the terms and conditions which we believe might be attractive basedon the current market situation. The availability of these terms and conditions depends onthe financial condition of Tractores Butterfly, the market, and political and regulatoryconditions at the time of any potential commitment.

If you agree with the attached terms and conditions, please sign and return a copy ofthis letter of acknowledgment. This proposal expires on January 30, 1999, unless renewedin writing.

We would appreciate the opportunity to work closely with you on this transaction and lookforward to hearing from you.

Yours sincerely,

Product Manager

cc: Relationship Manager

Figure 5.1: Indicative offer letter


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ANNEX

Summary of Indicative Terms and Conditions

Borrower / Exporter: Tractores Butterfly

Lender: Citibank N.A. or any of its subsidiaries or affiliates

Purpose: Financing for the production of 40 farm tractors for export

Type of Facility: Pre-export financeShort-term facility

Principal Amount: Up to USD 1,200,000

Tenor: Up to 180 days

Interest Rate: 6 months LIBOR plus a margin of 2.25% per annum, payableat maturity

Documentation: Promissory Note subscribed to by the borrower correspondingto the repayment of principal and interest

Taxation: All amounts payable under the Facility will be paid free andclear of all present and future taxes, withholding, duties, orother deductions whatsoever.

Governing Law: New York

Figure 5.2: Annex to the indicative offer


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January 20, 1999

Name and TitleTractores ButterflyAddressCity, State ZIP

Dear Mr. or Ms.:

You have requested Citibank to explore the possibility of arranging financing for theproduction of 40 farm tractors for export.

In response to your request, we are pleased to confirm our offer, subject to your acceptanceof the enclosed summary of indicative terms and conditions, on the basis of which CitibankN.A., or any of its affiliates and subsidiaries (“Citibank”), might be in the position to arrangefinancing for the above project.

Please confirm your acceptance of the present offer by returning to us a copy of this letter byclose of the business day January 30th, 1999, at which time this offer shall otherwise expire.

We look forward to hearing from you.

Yours sincerely,

Figure 5.3: Firm offer letter


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ANNEX

Summary of Indicative Terms and Conditions

Borrower / Exporter: Tractores Butterfly

Lender: Citibank N.A. or any of its subsidiaries or affiliates

Purpose: Financing for the production of 40 farm tractors for export

Type of Facility: Pre-export financeShort-term facility

Principal Amount: Up to USD 1,200,000

Tenor: Up to 180 days

Interest Rate: 6 months LIBOR plus a margin of 2.25% per annum,payable at maturity

Documentation: Promissory Note subscribed to by the borrower correspondingto the repayment of principal and interest

Taxation: All amounts payable under the Facility will be paid free andclear of all present and future taxes, withholding, duties, orother deductions whatsoever.

Governing Law: New York

Figure 5.4: Annex to firm offer


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UNIT SUMMARY

An important factor in developing trade-related business is torecognize the needs of our existing customers and potentialcustomers. We began this unit by describing the internal sources forinformation regarding existing customers. We also recommended aseries of questions for interviewing new customers. The questionsfocused first on the customer’s business and then on the customer’sclients and suppliers. The objective is to identify the customer’sneeds in order to structure the best solution to meet those needs.

We considered the factors that affect pricing: minimum return oncross-border risk, expected return on assets, revenue to expenseratio, and market quotations for similar risks. We discussed risks thataffect product pricing and presented guidelines for pricing thedifferent products. Finally, samples of letters for submitting andconfirming a proposal to the customer were explained and presented.

You have completed Unit 5, Identifying Customers’ Needs and Pricing Solutions. Pleasecomplete the Progress Check to test your understanding of the concepts and check youranswers with the Answer Key. If you answer any question incorrectly, please reread thecorresponding text to clarify your understanding.

After finishing the Progress Check, you will have completed this course on Basics ofTrade Services and Trade Finance. Congratulations! You may wish to duplicate severalsections of this unit to serve as quick references or reminders when you prepare tointerview new customers, work through the pricing process, and prepare the offer tothe customer. Good luck!


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þ PROGRESS CHECK 5

Directions: Determine the correct answer(s) to each question. Check your answers withthe Answer Key on the next page.

Question 1: Match each type of information about a potential customer with its internalCitibank source. Write the number of the source on the line next to the typeof information.

_____ a) Industry analysis and research 1) Credit area_____ b) Statistics on trade volumes 2) Trade product management unit_____ c) Country trade reports 3) FINCON

_____ d) Product / customer revenues 4) Relationship or product manager

Question 2: An interview with a prospective customer occurs and questions are askedto identify the prospect’s needs. Match the type of information the bankeris trying to uncover with the following questions. Write the number of thetype of information on the line next to the questions. You may use a numbermore than once.

_____ a) What does the customer sell? How much is sold locally?How much is exported?

_____ b) Does the customer purchase all supplies within the country?_____ c) Does the customer offer financing terms to his/her buyers?_____ d) Who are the customer’s offshore buyers?_____ e) How does the customer pay for imports?_____ f) How many banks does the customer use to process trade transactions?_____ g) Does the customer feel that there are any trade-related needs that are

not being properly addressed?

1) Customer’s current trade practices2) Product mix3) Suppliers4) Customer’s client5) Financing to the customer’s client6) Customer service


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ANSWER KEY

Question 1: Match each type of information about a potential customer with its internalCitibank source.

1 a) Industry analysis and research 1) Credit area

4 b) Statistics on trade volumes 2) Trade product management unit

2 c) Country trade reports 3) FINCON

3 d) Product / customer revenues 4) Relationship or product manager

Question 2: An interview with a prospective customer occurs and questions are askedto identify the prospect’s needs. Match the type of information the bankeris trying to uncover with the following questions. Write the number of thetype of information on the line next to the questions. You may use a numbermore than once.

2 a) What does the customer sell? How much is sold locally? How muchis exported?

3 b) Does the customer purchase all supplies within the country?

5 c) Does the customer offer financing terms to his/her buyers?

4 d) Who are the customer’s offshore buyers?

1 e) How does the customer pay for imports?

1 f) How many banks does the customer use to process trade transactions?

6 g) Does the customer feel that there are any trade-related needs that arenot being properly addressed?

1) Customer’s current trade practices2) Product mix3) Suppliers4) Customer’s client5) Financing to the customer’s client6) Customer service


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Question 3: Identify the key benchmark associated with each of the following situations.Write the number of the benchmark next to the situation.

_____ a) The banker evaluates current market conditions before pricing animport letter of credit.

_____ b) The product most suitable for the customer is labor intensive forthe Bank.

_____ c) In a foreign exchange transaction, regulations may prohibit theconversion of local funds to hard currency.

_____ d) If Citibank wants to book more assets, it may have to put up additionalcapital.

1) Minimum return on cross-border risk2) Expected rate of return on assets3) Market quotations for similar risks4) Revenue-to-expense ratio


_____ a) When pricing collections, transfers, or payment orders, quote a flatfee for a large number of transactions.

_____ b) It is necessary to know if an import letter of credit involves sovereignexposure.

_____ c) A local bank should reduce pricing for customers when it receivesoffshore fees as “customer revenue” not collected locally.

_____ d) When the export credit is a large one with multiple negotiations, rollthe costs for each negotiation into one quoted figure.

_____ e) Use LIBOR when the tenor is fixed.

_____ f) When selling trade paper, the quotation for a forfait is what the bankwill receive for the period accrued as of the date of the sale of the paper.


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ANSWER KEY

Question 3: Identify the key benchmark associated with each of the following situations.Write the number of the benchmark next to the situation.

3 a) The banker evaluates current market conditions before pricing animport letter of credit.

4 b) The product most suitable for the customer is labor intensive forthe Bank.

1 c) In a foreign exchange transaction, regulations may prohibit theconversion of local funds to hard currency.

2 d) If Citibank wants to book more assets, it must put up additional capital.

1) Minimum return on cross-border risk2) Expected rate of return on assets3) Market quotations for similar risks4) Revenue-to-expense ratio


F a) When pricing collections, transfers, or payment orders, quote a flatfee for a large number of transactions.

T b) It is necessary to know if the import letter of credit involves sovereignexposure.

F c) A local bank should reduce pricing for customers when it receivesoffshore fees as “customer revenue” not collected locally.

F d) When the export credit is a large one with multiple negotiations, rollthe costs for each negotiation into one quoted figure.

T e) Use LIBOR when the tenor is fixed.

T f) When selling trade paper, the quotation for a forfait is what the bankwill receive for the period accrued as of the date of the sale of the paper.


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Question 5: The proposal is submitted to the customer via the offering letter. Whichof the following are included in the letter?

_____ a) Date and address of the department that is making the offer

_____ b) Letter should be addressed to the president of the company

_____ c) Explanation of the correct procedure for accepting the offer

_____ d) Base interest rate

_____ e) Letter must be printed on letterhead from the legal department

Question 6: A Peruvian exporter is selling textiles to Germany in the amount of USD50 MM per annum. The export sales are cyclical and occur from May toSeptember. The exporter needs funds to produce the goods to be exported,for an amount of USD 15 MM for 270 days. The Citibank branch in Peruapproved the credit, and the Relationship Manager (RM) confirmed the lineof credit with funds to be disbursed at LIBOR (6.0% p.a.) plus 2.0% p.a.spread. The exporter may be able to repay part or all of the loan after thefirst 180 days by using the proceeds from the shipments made during theexport cycle. What pre-export financing arrangement will best meet theexporter’s needs? Assume that PRIME is 6.5% p.a.

_____ a) 180 days at LIBOR plus 2.00% p.a., 90 days at Prime plus 1.5% p.a.

_____ b) 270 days at LIBOR plus 2.00% p.a.

_____ c) 270 days at Prime plus 2.00% p.a.

_____ d) 270 days at Prime plus 1.50% p.a.

_____ e) 180 days at LIBOR plus 2.00% p.a.; 90 days with LIBOR differentialcharged back to the customer if LIBOR rates go up.


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ANSWER KEY

Question 5: The proposal is submitted to the customer via the offering letter. Whichof the following are included in the letter?

a) Date and address of the department that is making the offer

c) Explanation of the correct procedure for accepting the offer

d) Base interest rate

Question 6: A Peruvian exporter is selling textiles to Germany in the amount of USD50 MM per annum. The export sales are cyclical and occur from May toSeptember. The exporter needs funds to produce the goods to be exported,for an amount of USD 15 MM for 270 days. The Citibank branch in Peruapproved the credit, and the Relationship Manager (RM) confirmed the lineof credit with funds to be disbursed at LIBOR (6.0% p.a.) plus 2.0% p.a.spread. The exporter may be able to repay part or all of the loan after thefirst 180 days by using the proceeds from the shipments made during theexport cycle. What pre-export financing arrangement will best meet theexporter’s needs? Assume that PRIME is 6.5% p.a.

a) 180 days at LIBOR plus 2.00% p.a., 90 days at Prime plus 1.5% p.a.This is the best alternative considering that the customer will be able torepay after the first 180 days, because he has a fixed rate for the first180 days, and has the volatility of the Prime rate only from day 181 to theactual repayment date. Also, he does not have a prepayment fee, since heis financing the second part at prime. The problem with answer (b) is theprepayment penalties for the last 180 days, when the customer will beapplying the funds received for his exports.

Answer ( c ) is not the solution because of the spread. When we quote therelation between Prime and LIBOR to customers, it must result in the sametotal rate for the financing — in this case, 8.00% p.a. Unless specificallystatedin the documentation, the rate is agreed for both periods beginning on DayOne.

You may have considered answer (d), but it is only partially correct in bestmeeting the exporter’s needs because the exporter (in fact, both the bankand the customer) is running the prime volatility for the whole period, insteadof only for those days from Day 181 to the actual repayment date.


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Question 7: Which one of the following statements is true?

_____ a) For ALADI letters of credit, pricing must take into account theadded cross-border risk.

_____ b) For import letters of credit, an “all-in” quote includes correspondentbank charges.

_____ c) For low-value, multiple funds transfers, a commission rate with aminimum price should be quoted.

_____ d) Prime rate should be quoted when the tenor is fixed.


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ANSWER KEY

Question 7: Which one of the following statements is true?

b) For import letters of credit, an “all-in” quote includes correspondentbank charges.

Appendices

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APPENDIX A

GLOSSARY

Acceptance Time draft or bill of exchange that represents a promisemade by the buyer to honor the instrument at maturity. Anacceptance is created when the drawee places the word“accepted” across the face of a draft, followed by the dateand signature of the acceptor.

AcceptanceCommission Rate

Component of acceptance financing cost whichcompensates the bank for its assumption of credit riskand covers the administrative costs of the transaction

AcceptanceDiscount Rate

Discount to the face value of a draft in a banker’sacceptance financing. This component of acceptancefinancing represents the bank's charge for the use of fundsas well as the rate earned by the bank or an investor.

Acceptor Party that agrees unconditionally to pay the draft atmaturity

Advising Bank A bank in the beneficiary’s country — usually acorrespondent of the issuing bank — through which theissuing bank communicates the credit to the beneficiary

All-In Quote A quotation to a customer that includes all fees charged bythe banks involved in a trade transaction, both local andcorrespondent banks.

All-In Rate An interest rate quoted to a customer that contains all theelements of the bank’s costs and profit built into that rate.It is the total return the bank earns, and effectivelymeasures the customer’s true cost.

AllocatingCross Border

Citibank approval process for amount and type of businessthat can be done “cross border” with any particular country

Analysis Certificate Document used for mineral or chemical purchases to verifythe percentage of each component

Applicant Party (importer) that arranges for a Letter of Credit to beissued

A-2 GLOSSARY

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Asociación Latino-Americana deIntegración (ALADI)

Organization of Latin American countries that providesmembers with a source of financing for Latin Americanintraregional trade

Assignmentof Proceeds

Instructions of the beneficiary to the paying bank to payall, or a portion of, the proceeds of a Letter of Credit toa third party (assignee)

Aval Unconditional and irrevocable guarantee establishedby signing a promissory note or bill of exchange. Bysigning the note, the bank or other party commits itself topay should the drawee default.

Bank SecrecyAct (BSA)

US law that requires banks to file reports and keep recordsfor five years on matters that are useful in investigationsof criminal, tax, and regulatory violations

Banker’sAcceptance

Time draft drawn by the buyer on a bank and accepted bythe bank which will pay another party a stated amount ona predetermined future date. In a banker’s acceptance,payment at maturity is assured by a bank.

Bank-to-BankReimbursement

A trade product that is used when the letter of credittransaction between the applicant and beneficiary fromdifferent countries is denominated in a third-countrycurrency, usually US dollars

Basic InformationReport (BIR)

Document used for all new account openings in LatinAmerica to indicate that the bank has followed the know-your-customer policy, and that dealing with the customerconstitutes an acceptable, minimal risk

Beneficiary Party in whose favor the credit is issued (e.g. exporteror seller). The beneficiary can draw funds from thepaying bank.

Bid Bond Instrument designed to ensure that the tenderer (e.g.,supplier) will honor its commitment to a buyer whenbidding for a construction or supply contract

Bill of Exchange Unconditional order written from one person (the drawer)to another person (the drawee), directing the drawee topay a certain sum at “sight,” or at a fixed or future dateto be determined, to the payee.

GLOSSARY A-3

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Bill of Lading Transportation or shipping document, issued by thetransportation company when moving goods, that providesevidence of receipt of goods for shipment, a contract fortransportation, and documentary evidence of title on goods

Bond Instrument designed to ensure commitment made by oneparty (the bank) to another party (the obligee) pledging tocover for financial loss caused by the act of default of athird party (the obligor – the bank’s customer)

Boycott Explicit or implied request by a company or individualnot to do business with certain persons or companies

Bundled withTransactions

Pricing which takes into account the aggregate of productssold to the customer

Buyer’s CreditFinancing

A financing arrangement under which a lending bank in thesupplier’s country lends directly to the buyer, or to a bankin the buyer’s country, to enable the buyer to makepayments due to the supplier under the contract. The loanis insured by an export credit agency, and the lending bankusually receives a subsidy from its ECA.

Cash in Advance Payment method in which the seller receives cash from thebuyer before goods are shipped or services are rendered

Certificateof Origin

Document that states where goods were manufactured orgrown

Channelsof Trade

The time required for preparation for shipment, transport,receipt, and resale of goods

CiticorpInternational TradeIndemnity, Inc. (CITI)

A Citicorp subsidiary that underwrites trade-relatedinsurance (political risk, trade credit risk, and marinecargo) for Citicorp entities, corporate and bank customers,and other entities who participate in the flow of capitaland commerce across borders

Clean Risk One hundred percent risk that one party has honored itspart of the deal and cannot withdraw payment before thecounterparty goes bankrupt and defaults

Commercial A fixed rate; typically the rate in effect at the time the ECA

A-4 GLOSSARY

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Interest ReferenceRate (CIRR)

approves the export transaction as eligible for its support

CommercialInvoice

Billing document issued by the seller and addressed tothe buyer that gives a description of the goods or services,price, charges, etc.

Commercial Risk Possibility that the borrower is unable to generate sufficientlocal currency to purchase the necessary amounts offoreign currency to repay the financing(see Credit Risk)

Compliance Compliance is the act of conforming to a rule or demand.In banking, the term refers to conformance with legaland regulatory obligations in the countries of business.

Confirming Bank The bank which, under instruction in a Letter of Credit,adds its own irrevocable undertaking to that of theissuing bank and assumes the ultimate obligation topay on the Letter of Credit

Consignee Importer or agent responsible for paying for goods if andwhen they are sold

Consignment A method of payment for goods where the title of thegoods remains with the supplier / manufacturer until theyare sold by an agent or third party

ContingentLending Risk

Possibility that potential customer obligations willbecome actual obligations and will not be settled on time

ContractFrustration

Primary type of private insurance coverage for thecommercial and country risks of international trade; coversnon-payment resulting from specific country risks

Convertibility Risk Risk which exists in any transaction in which legal orregulatory barriers prevent the borrower from convertingits local currency into the foreign currency required forpayment when the obligation in that currency matures.Possibility that a local currency will not be convertibleto the currency needed to make payment to an exporter.

Correspondent A bank that provides services to another bank, includingfunds transfers, trade transactions, and financings. In order

GLOSSARY A-5

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Bank to operate appropriately, at least one of them should holdan account in the other one.

Counterparty Customer with whom the bank has a contract tosimultaneously pay agreed values at a stated future date

Counterparty Risk Possibility that a counterparty may default on a contract

Country Risk Possibility that the counterparty’s country may experiencepolitical or economic instability that makes it impossible toget money or physical assets out of that country (See alsoCross-Border Risk)

Country RiskInsurance

Insurance issued to protect against losses resulting fromactions or inaction of a sovereign government

Credit Line Maximum amount that a bank’s customer is entitled toborrow during any period of time. This amount enablesthat customer to initiate various loan transactions as longas their total amount does not go over, at any time, thelimit amount under the customer’s credit line.

Credit Risk Possibility that a borrower will be unable to repay a loan ontime or repay it in full (also known as Commercial Risk)

Cross-Border Risk A form of Country Risk (also includes Political[Sovereign], Transfer, and Convertibility Risk)

CurrencyTransactionReport (CTR)

One of the reports required under the Bank Secrecy Act(BSA) which Citicorp and all of its entities in the US mustfile with the Internal Revenue Service for every cashdeposit or withdrawal over $10,000

Deferred Payment See Payment, Deferred

Demand DepositAccount (DDA)

Account in which the depositor may withdraw funds whens/he wishes (on demand)

Deposit / Relending A funding mechanism for ECA-supported export financingwherein the ECA lends to the bank which, in turn, relendsto a borrower-buyer (importer)

Direct Lending A funding mechanism for ECA-supported export financingwherein the ECA lends directly to the buyer (importer);therefore, there is no finance earning opportunity for the

A-6 GLOSSARY

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banks

Direct Lending Risk Possibility that customer obligations will not be settledon time. It occurs in such products as loans, overdrafts,credit cards, and mortgages.

Discrepancy Any variation or difference between the requirements ofthe credit and what appears on the documents presentedfor negotiation

Document AgainstAcceptance (D/ACollection)

The release of title documents to the buyer uponacceptance of a time draft

Document AgainstPayment (D/PCollection)

The release of title documents to the buyer upon paymentof a sight draft

DocumentaryCollections

Collection method in which the goods are shipped to thebuyer, and the bank retains custody of the title documentsand delivers them to the buyer when the buyer pays forthe goods or commits itself for the payment

DocumentationRisk

Possibility that written instruments connected to a contractor transaction are incorrect, incomplete, or unenforceable

Draft A signed order by one party (the drawer) addressed toanother (the drawee) directing the drawee to pay aspecified sum of money to the order of a third person,the payee (See Bill of Exchange)

Drawdowns Scheduled payments to be made to the borrower which areset by the lending bank

Drawee The party on whom a bill of exchange, or draft, is drawnand from which payment is expected. The drawee maybe an individual, a corporation, or a bank.

Drawer One who signs a draft or bill of exchange (usually theseller, or beneficiary of a Letter of Credit)

EC See “European Community”

Eligible Banker’sAcceptance

Banker’s acceptance that meets certain criteria establishedby the US Federal Reserve Bank so that the issuing bank

GLOSSARY A-7

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does not have to maintain reserves against it

Endorsed /Endorsement

A signature on the back of a negotiable instrument madeprimarily for the purpose of transferring the rights of theholder to another person

Eurodollars Currency in US dollars deposited in a bank outside the USsuch as a foreign bank, an overseas bank of a US bank, oran International Banking Facility

EuropeanCommunity (EC)

Group of European countries that have joined togetherto establish a common market which assures the freemovement of people, goods, services, and capital

Expiration Date The final date upon which conforming drafts and/ordocuments under a Letter of Credit may be presentedto a bank for negotiation or payment

ExportAdministrationAct (EAA)

Legislation that imposes civil fines for violations of USanti-boycott laws and regulations

Export CreditAgency (ECA)

Government agency that provides preferential financingrates and terms for loans to foreign companies who buyfrom local exporters

Export Financing Financing provided to the exporter (seller) for the periodbetween shipment of goods and receipt of payment fromthe importer (buyer)

Export-ImportBank of the UnitedStates (EXIMBANK)

Export credit agency of the US government that providescredit support when competitive private financing isunavailable. Its programs include guarantees, insurance,and direct extensions of credit.

Exports Goods or services that a country sells to other countries

Firm Offer Letter confirming an indicative offer

Fixed Rateof Interest

Remains constant for the life of the financing

Floating Rateof Interest

Adjusted periodically, usually semi-annually, on dates whenrepayment installments of the loan principal are due

A-8 GLOSSARY

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ForeignExchange Risk

Risk resulting from purchasing or selling goods at a pricedenominated in a currency other than that of the purchaseror seller

Forfaiting Technique whereby the seller (exporter) can offer short-or medium-term financing to an overseas buyer by sellingthe buyer’s promissory notes, usually without recourse,at a discount to a forfaiter. The forfaiter, in turn, sells thenotes in the secondary market. Also known as “a forfait.”

General Agreementon Tariffs andTrade (GATT)

Organization of over 100 member countries with a set ofbilateral trade agreements created to abolish quotas andreduce tariff duties among participating nations

Guarantee Written promise to carry out another party’s obligation inthe event of default

Guaranteed Loan Loan for which repayment is guaranteed by another partyother than the borrower

Guarantor Party who extends a guarantee

ICC International Chamber of Commerce

Image Risk Possibility that an activity of the bank, or one of itsrepresentatives, will damage the reputation of Citibank

Import Financing Financing provided to the importer (buyer) so it can meetits obligations with the exporter

Imports Goods and services that a country buys from othercountries

Indicative Offer Initial offering letter sent to a customer

InspectionCertificate

Document issued by an independent third party when anoutside inspection is called for in the merchandise contract

InsuranceDocument

A title document indicating proof of ownership by anorganization or individual with the rights to claim forcompensation in the event of damage or loss ofmerchandise

GLOSSARY A-9

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Interest Make-Up A funding mechanism for ECA-supported export financingwherein the ECA compensates a lending bank for thedifference between its cost of funding plus spread andthe fixed interest rate on the loan to the borrower

Interest Rate Percentage that the bank charges the customer for usingborrowed funds, usually quoted on an annual basis

Interest Rate Risk Possibility that the interest rate at which the seller borrowsto cover the period between shipment of goods and receiptof funds may rise to the point where the transaction maybecome unprofitable

International Bankfor Reconstructionand Development(IBRD)

A legal, financial entity of the World Bank which makesmarket-rate loans to newly industrialized countries byborrowing in the world capital markets

InternationalBankingFacility (IBF)

Separate group of accounts set up by a US bank, or a USbranch of a foreign bank, to record international bankingtransactions. An IBF is located in the US and may offerdeposits denominated in currencies other than the dollar

InternationalDevelopmentAssociation (IDA)

A legal, financial entity of the World Bank which extendsassistance to the poorest developing countries on lenientterms (e.g., interest-free loans), largely from resourcesprovided by its wealthier members

InternationalFinanceCorporation (IFC)

An affiliate of the World Bank, it is the world’s largestmultilateral organization specifically structured to provideloans to — and equity investments in — private companiesin emerging markets

InternationalStandby Practices(ISP)

A publication by the International Chamber of Commerce(ICC) that provides guidelines for parties / participants instandby letter of credit transactions.

InventoryFinancing

Financing provided to the exporter (seller) so it may holdreadily marketable staples in storage and complete thesale of these staples to an importer (buyer) within theexporter’s country or overseas; the goods serve ascollateral for the loan

Irrevocable A term placed on an instrument to indicate that it canonly be amended or terminated prior to its expiration

A-10 GLOSSARY

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date with the consent of each party

Issuing orOpening Bank

Bank that opens (issues) the credit at the request of itscustomer (importer)

Know-Your-Customer Policy

Policy that requires financial institutions to monitornew and existing accounts to help identify suspiciouscustomer activity

Legal andRegulatory Risk

Possibility that the bank may face civil, criminal, andadministrative proceedings because a transaction failsto comply with all applicable laws and regulations

Lending Risk A category of credit risk which involves extensionsof credit and/or credit-sensitive products (loans andoverdrafts) where the bank takes the full risk for theentire life of the transaction

Letter of Credit A method of payment for goods or services. Instrumentissued by a bank in favor of a beneficiary (seller) by whichthe bank substitutes its own creditworthiness for that ofthe applicant (e.g. buyer)

Letter of Credit,Back-to-Back

Two independent Letters of Credit used jointly to facilitatethe purchase of the same goods

Letter of Credit,Commercial

A letter of credit intended as a payment method for goodsor services

Letter of Credit,Confirmed

An irrevocable Letter of Credit to which another bank,usually in the country of the exporter, has added itsirrevocable commitment to honor drafts and documents

Letter of Credit,Cumulative

A revolving letter of credit is cumulative when the letter ofcredit becomes re-available as to amount or quantity. Anyportion not utilized may be accumulated for later usedepending upon the wording in the Letter of Credit

Letter of Credit,Export

Letter of Credit opened by an overseas bank on behalf ofan overseas importer (buyer) in favor of a local exporteras payment for local goods purchased

GLOSSARY A-11

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Letter of Credit,Import

Letter of Credit opened by a local bank on behalf of a localimporter (buyer) in favor of an overseas exporter (seller)to secure payment for foreign goods purchased

Letter of Credit,Irrevocable

Letter of Credit that cannot be canceled or changedwithout the consent of the issuing bank, confirming bank(if the L/C is confirmed), and the beneficiary (seller)

Letter of Credit,Negotiable

Letter of Credit under which the issuing bank’s obligationextends to the drawer of the draft or any bona fide holderthereof

Letter of Credit,Red Clause

See “Red Clause”

Letter of Credit,Revocable

Letter of Credit that can be canceled or changed by theissuing bank at any time, without notifying or obtainingthe consent of the buyer

Letter of Credit,Revolving

Letter of Credit that, by its terms, renews its value overa given period, either automatically or by amendment

Letter of Credit,Standby

A standby Letter of Credit secures a transaction or theperformance of another party. A standby L/C is often usedin place of performance bonds or payment guarantees.

Letter of Credit,Straight

Letter of Credit under which the issuing bank’s obligationextends only to the Beneficiary

Letter of Credit,Transferable

Letter of Credit that allows the beneficiary to transfer thecredit to a second beneficiary

Letter of Guarantee Written promise to carry out another party’s obligation inthe event of default. The letter of guarantee is the MiddleEastern counterpart of a standby letter of credit

Leverage Power in a negotiation

Leveraged Returns Realizing greater revenue through use and managementof third party liabilities (credit) in a silent syndication dealto transfer some of the risk

LIBOR London Interbank Offer Rate, interest cost to a bank toobtain a deposit in the Eurodollar market

A-12 GLOSSARY

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Line of Credit The maximum amount which a customer is entitled toborrow from a bank at any given time. This amountallows a bank’s customer to undertake several lendingtransactions as long as their total amount does not exceed,at any given time, the amount granted under the line ofcredit.

Lloyds of London 300-year old insurance association located in London

Macroeconomics The study of the economy as a whole, as opposed to“microeconomics” which is the study of an individual firm,commodity, or consuming unit

Money Laundering Investment or transfer of money from illegal sources intolegitimate channels so that the original source of the fundscannot be traced

Money LaunderingControl Act (MLCA)

US law that makes money laundering a federal crime anddefines criminal offenses that are considered part of themoney laundering process

MultilateralAgencies (MLAs)

Institutions established by governments whose purposeis to maintain orderly international financial conditions andto provide capital and advice for economic development,particularly in those countries that lacksuch resources to do it themselves. The World Bank isan example of a multilateral agency.

MultilateralInvestmentGuaranteeAgency (MIGA)

An affiliate of the World Bank which was establishedto encourage foreign direct investment in emergingmarket countries by providing investment guaranteesand advisory services

Negotiable A term placed on an instrument (draft, Letter of Credit, orother document) which allows the title to be transferredfrom owner to owner by endorsement, usually evidencedby the use of the words “order of” or “to the order”

NegotiableInstrument

Instrument such as a bill of exchange, check, or promissorynote used as a payment device in international trade

Negotiating Bank A bank, usually unnamed in the Letter of Credit, whichelects to “negotiate” (purchase documents from, andadvance funds to, the beneficiary) against presentationof the documents required by, and complying with, the

GLOSSARY A-13

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Letter of Credit terms. Negotiation may be made withor without recourse.

NonsovereignFunding

Loan made to a Citibank branch for subsequent relendingto a local private borrower with an agreement that statesthat the branch is obliged to repay the loan / deposit unlesssome measure imposed by the local government preventsfunds from leaving the country

Nontariff Barrier Measure that restricts imports

North AmericanFree TradeAgreement (NAFTA)

1994 agreement to facilitate the flow of goods and capitalbetween the United States, Canada, and Mexico bycreating a free trade zone among their territories

Offering Letter Letter containing a structure and price proposal

Office of ForeignAssets Control(OFAC)

US Dept. of Treasury office which publishes extensive listsof specially designated nationals, terrorists, and narcoticstraffickers whose assets must be blocked, evenif located outside the “blocked” country

Offshore Vehicle See Vehicle, Offshore

On Consignment A method of payment for goods where the title to goodsremains with the supplier / manufacturer until they are soldby an agent or third party

Open Account Payment method in which the seller finances the buyer byshipping the goods without receiving payment or a writtenpromise to pay.

Open Syndication Risk transfer technique in which the investing banks actas a consortium and are disclosed to each other and tothe customer

Operational /Systems Risk

Possibility of a systems (technology) or manual error whichmay be internal and/or external to the bank

A-14 GLOSSARY

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Organizationfor EconomicCooperation andDevelopment (OECD)

International organization of industrialized, market-economy countries

Overseas PrivateInvestmentCorporation (OPIC)

US government agency whose primary objective isto insure or guarantee US investment overseas in theemerging markets

Packing List Document that indicates the contents of a packagebeing shipped

Pacto Andino Andean Pact, a 1969 agreement among Ecuador,Colombia, Chile, Bolivia, and Venezuela to form aLatin American common market within that region

Participation Trade financing structure with correspondent bank(s)assuming a certain percentage of Citibank’s exposureto the country and commercial risk of the borrower

Paying Bank Bank named in the Letter of Credit as the bank whichwill pay, without recourse, upon receipt of documentsin compliance with the Letter of Credit terms

Payment, Deferred A Commercial Letter of Credit payable on a specifiedfuture date. The beneficiary may present the complyingdocuments at an earlier date, but the Commercial Letter ofCredit is payable only on the specified future date

Payment, Sight A Commercial Letter of Credit is payable at sight when thebeneficiary presents the complying documents and if thepresentation takes place on or before the expiration of theCommercial Letter of Credit

Performance Bond Instrument designed to ensure that the contractor (e.g.,supplier) will perform and execute the contract inaccordance with all its terms and conditions

Performance Risk Possibility that an exporter may fail to perform underthe contract established with the importer

GLOSSARY A-15

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Political(Sovereign) Risk

Possibility that the actions of a sovereign government(e.g. nationalization or expropriation) or independentevents (e.g. wars, riots, civil disturbances) may affectthe ability of customers in that country to meet theirobligations to Citibank

Pre-ExportFinancing

Financing provided to the exporter (seller) with a firmcontract sale in order to acquire and prepare goods forshipment

Pre-Paymentof Exports

Pre-export financing offered by Citibank Brazil formanufacturing expenses associated with goods to beexported. Funding is advanced from an offshore vehicle,the principal repaid by the importer, and interest repaidby the exporter to the funding entity.

Pre-SettlementRisk (PSR)

Possibility that a counterparty may default on a contractualobligation to the bank before the settlement date of thecontract

Prime Rate Most favorable interest rate charged by a commercial bankon short-term loans to its most creditworthy customers

Product Risk Possibility that the structure of a trade product or service(e.g. Letter of Credit) is inadequate or faulty

Project Financing Financing, usually provided by multilateral agencies,with the intention of bringing economic value to animporter’s country. Such financing is extended on the basisof projected cash flows instead of traditional forms ofcollateral. Cash flows from the financed project areexpected to pay the interest and repay the principalamount which originally supported the project.

Promissory Note A written promise committing the signer (borrower) topay a certain amount to the payee (lender) at a future date,usually with interest

Quality Certificate Document that verifies that the merchandise to be shippedagrees with the quality standards requested for thatproduct

A-16 GLOSSARY

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Quota Restriction on the quantity of specific products that canbe imported and exported

Receivables Amounts owed to a company

Recourse A term used on a negotiable instrument to indicate thatthe drawer, or endorser, is liable to subsequent holdersfor payment at maturity

Red Clause A provision in a Letter of Credit that provides for theadvance of funds to the beneficiary prior to thepresentation of the stipulated documents

Return on Assets Measure of the bank’s performance in using assets togenerate earnings independent of the financing of thoseassets

Revocable A term placed on an instrument to indicate that it canbe modified or canceled without prior agreement fromeach party

Risk Transfer This strategy involves the identification and use oftechniques for shifting the political and/or commercial risksof international trade

Sanctions Economic measure adopted by one or several countriesto force a nation that is violating international law todiscontinue the offending behavior

Secured Loan Loan agreement that provides security to the bank bymeans of pledged collateral

SecurityAgreement

Document which links the collateral to a loan or creditfacility

Settlement Risk Possibility that the bank will deliver funds on the settlementdate of a contract, but not receive payment

ShippingDocuments

Transport, commercial, and any official documents whichare required by the exporter’s and importer’s countries tocertify the shipment of goods

Shipping Terms See Terms, Shipping

Sight Draft Draft payable upon proper presentation to the drawee

GLOSSARY A-17

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Sight Payment See Payment, Sight

Signature Books Security measure used by banks to verify customers’signatures

Silent Syndication Risk transfer syndication in which the customer does notknow that there are other investors in the transaction

Society forWorldwideInternationalFinancialTelecommunications(SWIFT)

A private international communication system used by thebanks to transfer funds by wire

Southern ConeCommon Market(MERCOSUR)

Agreement between Argentina, Brazil, Paraguay, andUruguay to create a common market for the membercountries

Sovereign Risk See “Political Risk”

SpeciallyDesignatedNational (SDN)

Person or company considered to represent thegovernments of sanctioned countries

Standby Letter ofCredit, GuaranteeType

Instrument that functions as a form of protection to coverperformance, financial or non-financial obligation, under acontract. It protects the beneficiary in the event that thebank’s customer fails to perform under a contract which isindependent of the Letter of Credit

Standby Letter ofCredit, PaymentType

Instrument that serves as a payment mechanism when anunderlying obligation is due, typically in connection withthe repayment of money, including any instrumentevidencing an obligation to repay borrowed money (e.g.promissory note)

Storage Financing Financing provided to US sellers for the storage of readilymarketable staples while their sale to US or foreign buyersis completed

A-18 GLOSSARY

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Supplier CreditFinancing

A financing arrangement under which the supplier agreesto accept deferred payment terms from the buyer, andfunds itself by discounting or selling the bills of exchangeor promissory notes so created with a bank in its owncountry. Payment is guaranteed by an insurance policyfrom an export credit agency.

Surety Bond Instrument designed to ensure financial compensation tothe buyer if the supplier does not perform contractually asagreed

Syndication Loan made by several banks or lenders that form anassociation to assume the responsibility and share therisks of the loan

Tariff Tax placed on imported goods

Tenor The length of time a bill is drawn to run beforepresentation for payment. The time between the date ofissue or acceptance of a note or draft and the maturitydate.

Term Loan Loan with a maturity greater than one year

Terms, Payment The terms under which a seller and buyer agree that theexchange of goods for payment shall take place. Openaccount, cash in advance, Letter of Credit, consignment,and documentary collection are examples of commonpayment terms.

Terms, Shipping Shipping terms stating, in abbreviated form, where theseller’s responsibility for the goods ends and where thebuyer’s begins; i.e. F.O.B. (Free On Board)

Test Keys Security measure used by banks to establish authenticity ofinstructions from bank to bank in a correspondentrelationship

Time Draft A draft payable at a fixed or determinable future dateafter presentation to the drawee

GLOSSARY A-19

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Title Document A legal document indicating proof of ownership by anorganization or individual of a certain merchandise

Trade Acceptance A time draft drawn by the seller of goods on the buyer,and accepted by the buyer, for payment at a specifiedfuture date. In a trade acceptance, payment of the timedraft is not assured by a bank.

Trade Agreement Agreement between two or more countries concerning thebuying and selling of each country’s goods and services

Trade CreditInsurance

Protects against political instability, the possibility ofregional or global economic problems, and natural disasters

Transfer Risk Possibility that a borrower is unable, due to legal orother barriers, to transfer funds in the foreign currencyof payment to the place of payment when its obligationin that currency matures

TransportDocument

A title document indicating proof of ownership by anindividual or organization toward the merchandisedescribed within the document; all types of documentsevidencing shipment or dispatch of goods, e.g. bill oflading, air waybill

Uniform Customsand Practice forDocumentaryCredits (UCP)

A publication of the ICC that explains the responsibilitiesof merchants and bankers in the operation of Letters ofCredit

Uniform Rules forCollections (URC)

A publication of the International Chamber of Commerce(ICC) that provides guidelines for parties / participantsinvolved in collections transactions

Unsecured Loan Loan not backed by a pledged collateral or securityagreement. Unsecured loans are granted on the financialstrength and reputation of the borrower.

A-20 GLOSSARY

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Usance Period Length of time allowed for payment

Vehicle, Offshore Facility used for booking international trade transactions.It is not a separate banking entity, but a separate group ofaccounts or bookkeeping systems set up by a US bank or aUS branch of a foreign bank to record internationalbanking transactions

WarehouseFinancing

See “Inventory Financing”

Warehouse Receipt Title document stating that a warehouse company isholding a certain quantity of a specific commodity. Thecompany will continue to hold these goods until thewarehouse receipt is exchanged for the merchandise.

Weight List Document that indicates the total gross and net weightsof the cargo

With Recourse Term used on an instrument or endorsement to indicatethat the drawer or endorser is liable to subsequent holdersfor payment at maturity

Without Recourse Term used on a negotiable instrument to indicate that thedrawer or endorser is not liable to subsequent holders forpayment at maturity

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Appendix BINDEX

A

Acceptance 2-17, 2-36, 2-37, 3-12, 3-24— 3-29, 3-32, 5-20

Acceptance Commission Rate 3-26, 3-27

Acceptance Discount Rate 3-26

Acceptor 3-24

Advising Bank 2-31, 2-34, 2-35, 2-44— 2-46, 2-52, 2-53, 2-57, 4-7, 5-14

Aging Certificate

All-In Quote 5-14, 5-33, 5-34

All-In Rate 3-27, 3-45

Allocating Cross Border 3-54, 4-10, 4-11

Analysis Certificate 2-78

Applicant 2-31, 2-32, 2-34, 2-35, 2-37, 2-40, 2-42, 2-43, 2-45, 2-46,2-48, 2-49, 2-51— 2-53, 2-56— 2-58, 3-25, 4-7, 5-15

Asociación Latino-Americanade Integración (ALADI)

1-10, 1-12, 5-14

Assignment of Proceeds 2-39, 2-41, 2-42

Aval 3-24, 3-31— 2-33, 2-35

B

Bank Secrecy Act (BSA) 4-41, 4-42

Banker’s Acceptance 2-74, 3-1, 3-23, 3-25— 3-29, 3-34, 3-36, 3-41, 3-55, 3-60, 4-3, 4-7, 4-8, 4-34, 4-41, 5-18

Bank-to-Bank Reimbursement 4-7, 4-8, 4-34

Basic Information Report (BIR) 4-43, 5-3

Beneficiary 2-31, 2-32— 2-49, 2-51— 2-53, 2-55— 2-58, 2-73, 3-25, 3-36, 3-48, 4-7, 4-14

Bid Bond 2-48, 2-55, 2-56, 2-65, 2-66, 2-69, 2-70

Bill of Exchange 2-73, 2-74, 2-78, 3-24, 3-29, 3-31, 3-33, 3-48

Bill of Lading 2-75, 2-78

Bond 2-49, 2-50, 2-54, 2-55, 2-56, 2-65, 2-66, 2-69

Boycott 4-1, 4-8, 4-33, 4-34, 4-36— 4-39, 4-43, 4-44

B-2 INDEX

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B (Continued)

Bundled with Transactions 5-18

Buyer’s Credit Financing 3-47, 3-53, 3-54

C

Cash in Advance 2-3— 2-5, 2-9, 2-18

Certificate of Origin 2-77

Channels of Trade 3-27

Citicorp International TradeIndemnity, Inc. (CITI)

3-51, 3-54, 4-16, 4-19, 4-20, 4-43

Clean Risk 3-54

Commercial Interest ReferenceRate (CIRR)

3-45

Commercial Invoice 2-12— 2-14, 2-75, 2-77, 2-78

Commercial Risk 1-16, 2-4, 2-5, 2-10, 2-11, 2-16, 2-17, 2-39, 2-43, 2-45,2-51, 2-53, 3-24, 3-46, 3-51, 3-53, 3-54, 3-56— 3-60, 4-3,4-10, 4-12, 4-13, 4-15— 4-20, 5-12, 5-14, 5-18

Compliance 2-35, 2-45, 4-1, 4-8, 4-33, 4-34, 4-39, 4-43, 4-44, 5-1

Confirming Bank 2-31, 2-32, 2-35, 2-38— 2-40, 2-44— 2-46, 2-52, 2-53, 2-57,3-57, 5-16

Consignee 2-9— 2-11

Consignment 2-3, 2-9— 2-11, 2-18

Contingent Lending Risk 4-2, 4-3, 4-21

Contract Frustration 3-52, 4-15

Convertibility Risk 2-56, 3-3, 3-59, 4-2, 4-5, 4-6, 4-10, 4-13, 4-18, 4-21, 5-9

Correspondent Bank 2-55, 3-1, 3-55— 3-60, 5-14, 5-15

Counterparty 4-3, 4-4, 4-13

Counterparty Risk 3-8, 4-14, 4-21

Country Risk 1-13, 1-16, 2-4, 2-7, 2-9, 2-17, 2-39, 2-43— 2-45, 2-51— 2-53,2-57, 2-58, 3-3, 3-6, 3-29, 3-34, 3-35, 3-41, 3-42, 3-44, 3-46,3-51— 3-54, 3-56— 3-60, 4-2, 4-4, 4-5, 4-7, 4-10— 4-12,4-15— 4-22, 4-43, 5-12, 5-14, 5-18

Country Risk Insurance 4-15, 4-43

INDEX B-3

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C (Continued)

Credit Line 3-7, 3-11, 4-11

Credit Risk 2-4, 2-5, 2-9— 2-11, 2-16, 2-42— 2-45, 2-51— 2-53, 2-57, 3-5,3-26, 3-28, 3-29, 3-34, 3-35, 3-42, 3-46, 3-52, 4-2— 4-4, 4-7,4-9, 4-10, 4-13, 4-15, 4-16, 4-21, 5-12

Cross-Border Risk 2-1, 2-7, 2-8, 2-10, 2-11, 2-16, 2-39, 2-57, 3-3, 4-2, 4-4— 4-6,4-10— 4-13, 4-21, 4-43, 5-9— 5-11, 5-14, 5-25

Currency TransactionReport (CTR)

4-42

D

Deferred Payment See “Payment, Deferred”

Demand Deposit Account (DDA) 5-7

Deposit / Relending 3-43, 3-44, 3-60

Direct Lending 1-13, 3-43, 4-11

Direct Lending Risk 4-2— 4-4, 4-21

Discrepancy 2-33

Document Against Acceptance(D/A Collection)

2-14, 2-15, 3-13

Document Against Payment(D/P Collection)

2-3, 2-9, 2-12, 2-13, 2-15— 2-18, 3-24, 4-7, 4-8,4-34, 4-41, 5-13

Documentary Collections 2-3, 2-9, 2-12, 2-13, 2-15— 2-18, 3-24, 4-7, 4-8,4-34, 4-41, 5-13

Documentation Risk 4-2, 4-7, 4-8, 4-13, 4-21

Draft 2-6, 2-12— 2-15, 2-17, 2-37, 2-38, 2-45, 2-53, 2-73, 2-74, 2-78, 3-23— 3-26, 3-28, 3-31, 3-32, 3-35, 3-52, 3-53, 5-18

Drawdowns 3-7

Drawee 2-73, 3-24, 3-33

Drawer 2-73, 3-26

B-4 INDEX

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E

EC See “European Community”

Eligible Banker’s Acceptance 3-13, 3-27, 3-28

Endorsed / Endorsement 2-17, 2-49, 2-76

Eurodollars 3-4, 3-5, 3-15

European Community (EC) 1-1, 1-5— 1-7, 1-9

Expiration Date 2-32, 2-41

Export Administration Act (EAA) 4-37, 4-38

Export Credit Agency (ECA) 1-1, 1-6, 1-12, 1-13, 1-15, 1-17, 3-10, 3-23, 3-36, 3-41—3-55, 3-60, 4-14, 4-16, 4-17, 4-22, 4-43, 5-19

Export Financing 1-13, 1-15, 3-1, 3-9— 3-13, 3-23, 3-25, 3-36, 3-41, 3-43,3-46, 3-48, 3-50— 3-52, 3-55, 3-58, 3-60, 4-18, 5-22— 5-24

Export-Import Bank of theUnited States (EXIMBANK)

3-43, 3-50, 3-54, 4-17, 4-19, 4-20

Exports 1-1, 1-5, 1-6, 1-12, 1-13, 1-17, 2-7, 2-45, 3-41, 4-11, 4-16,4-37, 5-2, 5-4, 5-7

F

Firm Offer 3-32, 5-19, 5-23, 5-24

Fixed Rate of Interest 3-4, 3-5, 3-34, 3-42, 3-44, 3-45, 5-17, 5-18

Floating Rate of Interest 2-8, 3-4, 3-5, 3-44, 3-45, 5-17, 5-18

Foreign Exchange Risk 1-16, 2-7, 2-8, 2-10, 2-11, 2-16, 2-17, 2-43, 2-45, 2-51, 2-53, 2-57, 2-58

Forfaiting 3-1, 3-23, 3-29— 3-36, 3-41, 3-53— 3-55, 3-59, 3-60, 4-17,4-18, 4-22, 4-43, 5-18

G

General Agreement on Tariffsand Trade (GATT)

1-5, 1-10, 1-11

Guarantee 1-8, 1-11— 1-13, 1-15, 2-39, 2-47, 2-48, 2-54, 2-56, 3-24,3-29— 3-31, 3-33, 3-35, 3-42, 3-44, 3-46— 3-48, 3-50, 3-51,3-53, 3-54, 3-60, 4-15— 4-17, 4-22, 5-17, 5-19

Guaranteed Loan 3-6

Guarantor 3-6, 3-30, 3-35

INDEX B-5

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I

ICC 1-2, 2-18, 2-33, 2-34

Image Risk 4-2, 4-7, 4-21

Import Financing 3-11, 3-13, 3-52, 3-58, 5-10, 5-16, 5-17

Imports 1-4, 1-5, 1-12, 1-13, 2-7, 2-9, 5-2, 5-6, 5-7

Indicative Offer 5-19, 5-21— 5-24

Ineligible Banker’s Acceptance 3-27, 3-28

Inspection Certificate 2-77, 2-78

Insurance Document 2-6, 2-75, 2-76, 2-79

Interest Make-Up 3-43— 3-45, 3-50, 3-60

Interest Rate 1-13, 2-8, 3-4— 3-6, 3-14, 3-25, 3-31, 3-35, 3-42, 3-44, 3-45, 3-54, 3-60, 5-17, 5-22, 5-24

Interest Rate Risk 2-8, 2-16, 2-17, 3-35

International Bank forReconstruction andDevelopment (IBRD)

1-14

International BankingFacility (IBF)

3-4, 3-8, 3-12, 3-58, 4-6

International DevelopmentAssociation (IDA)

1-14

International FinanceCorporation (IFC)

1-14, 1-15

International Standby Practices(ISP)

2-33

Inventory Financing 3-11, 3-14

Irrevocable 2-32, 2-38, 2-47— 2-49, 2-57, 3-31

Issuing or Opening Bank 2-31— 2-35, 2-37— 2-46, 2-51— 2-54, 2-57, 2-58, 4-7, 4-13,4-38, 5-14— 5-16

K

Know-Your-Customer Policy 4-42

B-6 INDEX

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L

Legal and Regulatory Risk 3-28, 4-2, 4-7, 4-8, 4-10, 4-21, 4-33

Lending Risk 3-3, 4-2— 4-4, 4-21

Letter of Credit 2-31— 2-44, 2-46— 2-48, 2-51, 2-52, 2-56— 2-58, 2-73,2-74, 2-76, 3-13, 3-25, 3-34, 3-56, 3-57, 3-60, 4-7, 4-13,4-17, 4-37, 4-39, 5-5, 5-10, 5-14— 5-16

Letter of Credit, Back-to-Back 2-39— 2-41

Letter of Credit, Commercial 2-1, 2-33— 2-37, 2-39, 2-42, 2-45, 2-47, 2-58, 3-58

Letter of Credit, Confirmed 2-32, 2-38, 2-39, 2-43, 2-51, 2-57, 2-58, 3-57, 3-58, 3-61, 4-11, 4-13, 4-17

Letter of Credit, Cumulative 2-39

Letter of Credit, Export 2-46, 5-12

Letter of Credit, Import 2-46, 5-11, 5-14, 5-15

Letter of Credit, Irrevocable 2-32, 2-37— 2-40, 2-47— 2-49, 2-57

Letter of Credit, Negotiable 2-37, 2-38

Letter of Credit, Red Clause See “Red Clause”

Letter of Credit, Revocable 2-32, 2-47— 2-49, 2-57

Letter of Credit, Revolving 2-39

Letter of Credit, Standby 2-1, 2-33, 2-47— 2-53, 2-56, 2-58

Letter of Credit, Straight 2-37

Letter of Credit, Transferable 2-39, 2-41, 2-42

Letter of Guarantee 2-54, 2-56, 3-33

Leverage 2-1, 2-3, 2-5, 3-54

Leveraged Returns 4-21

LIBOR 3-5, 3-44, 3-45, 5-13, 5-16— 5-18, 5-22, 5-24

Line of Credit 3-7, 3-11, 4-11

Lloyds of London 3-51, 4-16, 4-43

M

Macroeconomics 1-9, 3-51

Money Laundering 4-1, 4-33, 4-34, 4-41, 4-42, 4-44

Money Laundering Control Act(MLCA)

4-41, 4-42

INDEX B-7

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M (Continued)

Multilateral Agencies (MLAs) 1-1, 1-6, 1-12— 1-15, 1-17, 3-41, 3-50, 3-51, 3-55, 3-61

Multilateral InvestmentGuarantee Agency (MIGA)

1-14, 1-15

N

Negotiable 2-17, 2-76, 3-28, 3-30, 3-31

Negotiable Instrument 2-17, 2-18, 2-74

Negotiating Bank 2-37, 2-38, 2-44— 2-46, 2-57, 2-74, 4-7

Nonsovereign Funding 3-57— 3-59, 3-61

Nontariff Barrier 1-3— 1-5, 1-17

North American Free TradeAgreement (NAFTA)

1-5, 1-6, 1-8

O

Offering Letter 5-1, 5-19, 5-20

Office of Foreign AssetsControl (OFAC)

4-35, 4-36

Offshore Vehicle See “Vehicle, Offshore”

On Consignment 2-3, 2-9— 2-11, 2-18

Open Account 2-3, 2-4, 2-6— 2-9, 2-18, 3-13, 5-7

Open Syndication 4-14

Operational / Systems Risk 2-16, 2-18, 2-40, 2-43— 2-45, 2-52, 2-53, 2-57, 3-28, 4-2,4-7, 4-8, 4-21

Organization for EconomicCooperation and Development(OECD)

3-49, 3-50

Overseas Private InvestmentCorporation (OPIC)

1-15, 1-16

B-8 INDEX

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P

Packing List 2-77

Pacto Andino 1-5, 1-6, 1-9, 1-10, 1-17

Participation 1-8, 3-57, 3-60, 3-61, 5-18

Paying Bank 2-31, 2-33, 2-35, 2-37, 2-40, 2-42, 2-44— 2-46, 2-52, 2-53, 2-57, 3-25, 3-26

Payment, Deferred 2-36, 2-67, 2-68

Payment, Sight 2-36, 2-67, 2-68

Performance Bond 2-48, 2-55, 2-56, 2-69, 2-70, 4-15

Performance Risk 4-2, 4-7, 4-9, 4-21

Political (Sovereign) Risk 2-1, 2-4, 2-5, 2-7, 3-3, 3-60, 4-2, 4-4, 4-5, 4-10— 4-12,4-16, 4-18, 4-19, 4-21, 4-43, 5-9

Pre-Export Financing 3-11, 3-14, 3-28, 5-9, 5-10, 5-12, 5-17, 5-18, 5-21, 5-22, 5-24

Pre-Payment of Exports 3-12

Presettlement Risk (PSR) 4-2, 4-4, 4-21

Prime Rate 3-4, 3-5, 3-28, 5-17, 5-18

Product Risk 4-2, 4-7

Project Financing 1-15, 3-41, 3-50, 3-51, 5-23

Promissory Note 2-6, 2-73, 2-74, 2-78, 3-7, 3-29— 3-33, 3-35, 3-36, 3-48, 3-53, 3-58, 3-59, 5-22, 5-24

Q

Quality Certificate 2-77, 2-78

Quota 1-3, 1-5, 1-11, 1-17, 4-10

R

Receivables 2-43, 3-11, 3-14, 3-48, 4-15, 4-17— 4-19

Recourse 2-38, 2-53, 4-19

Red Clause 2-39, 2-40

INDEX B-9

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R (Continued)

Return on Assets 4-21, 5-9, 5-10, 5-25

Revocable 2-32, 2-47, 2-49, 2-50, 2-57

Risk Transfer 3-52, 4-12— 4-14, 4-17, 4-18, 4-20, 4-21, 4-43

S

Sanctions 4-1, 4-8, 4-33— 4-36, 4-39, 4-43, 4-44

Secured Loan 3-6, 3-13

Security Agreement 3-6

Settlement Risk 4-2, 4-4, 4-21

Shipping Documents 2-33, 2-47, 2-75, 2-78, 3-12, 3-33

Shipping Terms See “Terms, Shipping”

Sight Draft 2-13, 2-49, 2-74, 3-23

Sight Payment See “Payment, Sight”

Signature Books 3-56

Silent Syndication 4-13, 4-20, 4-21

Society for WorldwideInternational FinancialTelecommunications (SWIFT)

4-8

Southern Cone Common Market(MERCOSUR)

1-5, 1-6, 1-9

Sovereign Risk 2-4, 3-3, 4-5, 4-10

Specially Designated National(SDN)

4-35

Standby Letter of Credit,Guarantee Type

2-47, 2-48, 2-50, 2-69, 2-70

Standby Letter of Credit,Payment Type

2-47, 2-49, 2-50, 2-69, 2-70

Storage Financing 3-13

Supplier Credit Financing 3-10, 3-11, 3-13, 3-47, 3-48, 3-50, 3-61, 4-12— 4-14, 4-20— 4-22, 4-43

Surety Bond 2-48, 2-50, 2-51, 2-55

Syndication 3-6, 3-8

B-10 INDEX

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T

Tariff 1-3— 1-5, 1-7, 1-9, 1-10, 1-11, 1-17

Tenor 3-5, 3-12, 3-27, 3-28, 4-11, 4-20, 5-5, 5-7, 5-10, 5-15, 5-16, 5-20, 5-22, 5-24

Term Loan 1-13, 1-16, 3-4, 3-6, 3-7

Terms, Payment 2-2, 2-3, 2-9, 2-32, 5-6, 5-8

Terms, Shipping 2-34

Test Keys 3-56

Time Draft 2-14, 2-15, 2-17, 2-37, 2-74, 3-24, 3-25, 3-36

Title Document 2-6, 2-12, 2-16— 2-18, 2-45, 2-75, 3-13

Trade Acceptance 3-24, 3-36

Trade Agreement 1-1, 1-5, 1-6, 1-10, 1-11, 1-17

Trade Credit Insurance 4-15, 4-43

Transfer Risk 2-57, 3-3, 3-4, 3-60, 4-1, 4-2, 4-5, 4-6, 4-14, 5-9

Transport Document 2-6

U

Uniform Rules for Collections(URC)

2-18

Uniform Customs and Practicefor Documentary Credits (UCP)

2-33

Unsecured Loan 3-6

Usance Period 3-24

V

Vehicle, Offshore 3-4, 3-8, 3-12

INDEX B-11

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W

Warehouse Financing 3-13

Warehouse Receipt 3-13

Weight List 2-77

With Recourse 5-5

Without Recourse 2-31, 2-37, 2-38, 3-24, 3-29, 3-30, 3-33, 4-17

Basics of Trade Services and Trade Finance January 1999

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Transcript of Basics of Trade Services and Trade Finance January 1999