Banker’s Acceptance Definition
Banker’s Acceptance is a financial instrument that is guaranteed by the bank (instead of the account holder) for the payments at a future date. It simply means that the bank has accepted the liability to pay the third party in case the account holders defaults. It is commonly used in cross border trade for assuring exporters against counterparty default risk.
How Does Banker’s Acceptance Work?
An importer enters into a transaction with the exporter from another country. The exporter is ready to supply the whole quantity till the port of the importer country. However, the exporter needs an assurance of payment. On the other hand, the importer is doubtful whether the exporter will supply the goods with the correct quantity and of appropriate quality after full payment is made to the exporter.
Hence both the parties have some transaction-related risks. Here is where banker’s acceptance comes into play.
The banker of the importer provides assurance through the banker’s acceptance to the exporter. The exporter is reasonably assured of the payment as the bank guarantees it. This facilitates trade between the parties. In case of any concerns about the quality and/or quantity of the goods, the exporter and importer can decide accordingly.
This provides financial support to importers as well. If everything goes well, the banker clears the payment on the due date specified on the banker’s acceptance. For such a service, the financial banker will charge a commission to the account holder.
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Source: Banker’s Acceptance (wallstreetmojo.com)
Example
Suppose, a US Company wants to purchase 1000 units of mobiles at an accumulated price of $1 million from a German company. US bankers issue Bankers Acceptance to the German firm for a credit periodCredit PeriodCredit period refers to the duration of time that a seller gives the buyer to pay off the amount of the product that he or she purchased from the seller. It consists of three components - credit analysis, credit/sales terms and collection policy.read more of 40 days. Once the exporter ships the mobiles, it provides the evidence (i.e. documents) to the US Bank and receives the banker’s acceptance.
Now, the German firm has the option either to hold the bill until maturity or discount it today through the German Bank. Through discounting, it receives the amount today itself with a cut of say 6.235 %, i.e. it receives $ 937,650. This is called discounting of the bill.
Now, the German banker has further options either to hold till maturity to receive $ 1 million or to discount it further to another party. This goes on till the banker’s acceptance is held till maturity. The ultimate holder receives the face value.
Characteristic
- The banker’s acceptance is issued against the creditworthiness of the party. The banker receives a commission for facilitating such trade, and thus bank’s profit is involved in the successful execution of the contract.
- Banker’s acceptance is available only for customers with good credit history. Such customers are usually corporate entities with good credit history. Such creditworthiness is also linked to the investment in bonds.
- Another characteristic is its marketability. It is a short-term debt instrumentDebt InstrumentDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more that can be traded in the market, i.e. such an instrument can be sold in the market. In such a case, the liability to pay for the debt is transferred to an altogether third party. Such transfer is feasible only due to the ethical practice & stringent credit evaluation rules followed by the entity.
- Banker’s acceptance is known for its easy conversion from instrument to real hard money. It is said to have higher liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses.read more since the amount is passed from the bank holder’s account to the debit account at the time of the creation of the instrument. Thus, there is confirmation of liquidity with lower risk.
Obtaining Banker’s Acceptance
- A business entity who wants to enter into a transaction of high value will approach its banker with which it has an account. It needs to provide details of the trade to be executed and the amount of credit required.
- The banker will assess the creditability of the account holder on various grounds & particularly the credit history of the account holder. If it is satisfied on all fronts, it will accept the liability on behalf of the account holder.
- The account holders need to prove the availability of sufficient funds on the date of execution and have to pay for the charges to the bank.
Banker’s Acceptance Rates and Marketability
Due to the banker’s acceptance of the liability to pay for the debt is guaranteed by the bank, the instrument is assumed as a safe investment by the market players. Thus, such an instrument can be traded at a discount to face. The discount to face value is nothing but the interest rate charged at a nominal spread over the US treasury billsTreasury BillsTreasury Bills or a T-Bill controls temporary liquidity fluctuations. The Central Bank is responsible for issuing the same on behalf of the government. It is given at its redemption price and a discounted rate and is repaid when it reaches maturity.read more.
For example, say the banker has an acceptance liability of $ 150000 for trade to be executed. The holder (i.e. the exporter) to whom such assurance is provided, can sell the instrument in the secondary market say at $ 145000. This way, the liability of bankers does not change. Such trading in the secondary market proves the marketability of the instrument.
Benefits
- The account holder (i.e. the importer) against whose default the assurance is provided, need not pay the amount in advance. The liability amount gets debited only the due date of payment.
- Banker’s acceptance facilitates trade between the two unknown parties. This helps build trust between the business entities.
- The exporter is assured about its payment, and the importer is assured about the timely receipt of goods.
- The exporter need not worry about default since a financial institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more of a country guarantees the payment.
- It provides an additional hedge to the trade at the nominal amount charged by the banker.
- Guarantees in payment promote the business.
Risks
- The primary risk of a financial banker is the inability to pay by the account holder. The banker has accepted the risk of default. The bank will have to honour the payment even if the account holder does not maintain sufficient funds on the date of payment. This is the reason why all banks do not issue banker’s acceptance.
- To hedge the risk of the banker, it may ask the importer to provide collateral security in the name of the bank.
- Even if the banker has done the fundamental check, it still faces the liquidity risk from the importer.
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