A Letter of Credit is a letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase.
In PrecisionLender, Letter of Credit is a payment type that can be available for any product in the product assumptions screen, although we suggest setting it up as its own product in order to be able to set the Usage Given Default accurately (See Setting Up Commercial Loan Products).
Usage Given Default
Usage Given Default (UGD) vs Loss Given Default (LGD)
When setting up a Letter of Credit product, additional thought must be given to the Risk Grades and ensuing Annual Loss and Credit Capital adjustments. Since a Letter of Credit would not typically carry an average balance, there is theoretically no potential Loss Given Default (LGD). Therefore, the Provisioning and Capital factors are multiplied against a $0 LGD which returns a $0 Provision and $0 Capital position.
In PrecisionLender we allow you to set a Usage Given Default (UGD) which would create a LGD. It is recommended to set the UGD at 100% as banks legally cannot stop the full payment from going out on a Letter of Credit once it has been negotiated. We also recommend that you set a Minimum Capital Allocation and vary that by risk grade.
The Usage Given Default (UGD) and the Minimum Capital Allocation can be set in the Risk Ratings section of the product assumptions screen, as seen in the image below.
Our Approach to Usage Given Default
Historically, we have used the same stair-step approach to the Usage Given Default (UGD) as we use on other products such as Lines of Credit where the borrower has the ability to draw down on the facility at any time without prior approval from the bank. Typically, we configure the UGD such that the best risk grades have the highest UGD input (90-100%) and then as the risk rating deteriorates the UGD stair-steps down in 5%-10% increments and typically bottoms out at around 50-60% for non-pass grades.
This approach to UGD does not work well for Letters of Credit because the nature of most standby LCs is that the probability of a draw is generally very low (<10%), but if there is a draw down it will typically be for 100% of the LC commitment. For this reason, we recommend setting the UGD default for a Letter of Credit to 100%.
Our Recommended Defaults:
Usage Given Default - on Letters of Credit our recommended default is 100%.
Fee – Because Standby Letters of Credit are not intended to be drawn down (with no outstanding principal balance earning interest), the primary form of income on an LC will be origination fees. Typically, 1-2% is standard.
Collateral – We advise that most Standby Letters of Credit be collateralized by cash, marketable securities or similar highly liquid, high quality collateral. The reason for this is that if a Standby LC is presented for payment it is usually the result of the customer failing to perform under the terms. The bank, therefore, does not want to be the last one to be holding the bag if performance concerns arise.
Letter of Credit Type
The Letter of Credit type determines the Regulatory Usage which is used to calculate the Regulatory Risk Weighted Assets.
|Letter Of Credit Type||Regulatory Usage|
0.2 For Maturities less than 365 days
0.5 For Maturities 365 days or longer
|Commercial - Self Liquidating||0.2|