A standby letter of credit is a guarantee by a bank to pay a third party if a client of the bank is unable to do so. This arrangement is sometimes demanded by a third party that wants to ensure itself of the credit quality of a prospective customer, especially in international trade deals. If the buyer does not pay by the agreed date, the seller can present the standby letter of credit to the buyer’s bank, which is obligated to make the payment on behalf of the buyer.
The bank providing the guarantee will not do so until it has engaged in a sufficient amount of due diligence regarding the credit standing of its client, and typically will require that the client set aside an adequate amount of collateral to ensure that the bank will be repaid in the event that it must make a payment to a third party under the arrangement. The client must pay the bank a fee on an annual basis to maintain the standby letter of credit arrangement, which is calculated as a percentage of the amount that the bank is guaranteeing.