What Is Banker’s Acceptance?
Banker’s Acceptance refers to the consent and promise that a bank gives or makes to a party exporting products to its native nation. In the process, the bank (instead of the account holder) guarantees for the payments at a future date, thereby ensuring smooth export and import relationship between countries without any financial disturbance.
Through banker’s acceptance, the bank accepts the liability to pay the third party if the account holder defaults. It is commonly used in cross-border trade to assure exporters against counterparty default risk. This helps exporters trust the country importing the goods on financial terms as the former knows they would receive the payment anyway.
Table of contents
- Banker’s acceptance is a financial instrument in which a bank guarantees payment to a third party at a future date, rather than the account holder guaranteeing the payment.
- The bank assumes responsibility for paying the third party if the account holder defaults on the payment.
- Banker’s acceptance is typically used in cross-border trade to protect exporters from counterparty default risk.
- The bank assesses the account holder’s credibility on various grounds, including their credit history. If the account holder meets the bank’s criteria, the bank will assume responsibility on their behalf.
How Does Banker’s Acceptance Work?
Banker’s acceptance, as the name, suggests is the scenario where the bank of one party agrees to pay for the products received from another party in case the former is unable to do so. This guarantee coming from the bank itself enables the exporters or the sellers to trust the importers and transport goods to them even if the payment is to be made at a future date. In short, this arrangement helps avoid any disturbance in the trade relations of two nations.
Here, an importer enters into a transaction with the exporter from another country. A business entity that wants to enter into a high-value transaction will approach its banker with an account. It must provide details of the trade to be executed and the amount of credit required.
The banker will assess the credibility of the account holder on various grounds, particularly the account holder’s credit history. If it is satisfied on all fronts, it will accept the liability on behalf of the account holder. The account holders must prove sufficient funds on the execution date and pay for the charges to the bank.
The exporter is ready to supply the whole quantity to the port of the importer country. First, 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 appropriate quality after full payment is made to the exporter.
Hence, both the parties have some transaction-related risks. Here is where a banker’s acceptance comes into play.
The importer’s banker assures the banker’s acceptance to the exporter. The exporter is reasonably assured of the payment as the bank guaranteesBank GuaranteesThe term “Bank Guarantee,” as the name suggests, is the guarantee or assurance given by a financial institution to an external party if the borrower cannot repay the debt or meet its financial liability. In such an event, the bank will repay such an amount to the party that has been issued with the guarantee. it. It 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.
It 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. The financial banker will charge a commission to the account holder for such a service.
Banker’s acceptance is one of the most significant concepts in the world of export-import. It allows two parties to trust each other with the items sold and the payments made. However, for this financial instrument to be active, there are a few things that one must be aware of. The characteristics that define how and in which scenarios such options work include the following:
- The banker’s acceptance is issued against the parties’ creditworthiness.CreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan. The banker receives a commission for facilitating such trade. Thus, the bank’s profit is involved in the successful execution of the contract.
- The 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 investmentInvestmentInvestments are typically assets bought at present with the expectation of higher returns in the future. Its consumption is foregone now for benefits that investors can reap from it later. 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. that can trade in the market, i.e., sell it. In such a case, the liability to pay for the debtDebtDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state. is transferred to an altogether third party. Such transfer is feasible only due to the entity’s ethical practice and stringent credit evaluation rules.
- Banker’s acceptance is known for its easy conversion from instrument to real hard money. In addition, it is said to have a higher liquidityLiquidityLiquidity is the ease of converting assets or securities into cash. since the amount is passed from the bank holder’s account to the debitDebitDebit represents either an increase in a company’s expenses or a decline in its revenue. account at the time of the instrument’s creation. Thus, there is confirmation of liquidity with lower risk.
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Let us consider the following instances to understand the concept better and also check how it actually works in a practical scenario:
Suppose a U.S. company wants to purchase 1,000 units of mobiles at an accumulated price of $1 million from a German company. The U.S. 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. 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.
The German firm can hold the bill until maturity or discount it today through the German bank. By ignoring it, it receives the amount today with a cut of 6.235%, i.e., $9,37,650. That is called discounting of the bill.
The German banker has further options to hold until maturity to receive $1 million or discount it further to another party. That goes on till the banker’s acceptance is held till maturity. The ultimate holder gets the face value.
Canadian Fixed-Income Forum (CFIF) published a whitepaper in January 2023 stating how Canadian Dollar Offer Rate cessation will be impact banker’s acceptance (BA) to a great extent. According to the report, these BAs would not exist and hence, the market participants must look for effective options that could replace BAs.
BAs, occupying a significant place in the Canadian market, would be tough to replace and hence around 80 industry experts joined the workshop conducted by the CFIF to explore alternatives of this process. They all agreed to develop new types of investment products that would make it easier for people to transition from BAs.
With the CDOR cessation date nearing, the BAs issuance rate would drop relatively. The Canadian market, as a result, is likely to witness the efficient issuance of the banker’s acceptance by the end of 2023. However, this would be little or no more active starting June 2024.
Banker’s Acceptance Rates and Marketability
Due to the banker’s acceptance of the liability to pay for the debt guaranteed by the bank, the instrument is assumed to be a safe investment by the market players. Thus, they can trade such an instrument at a discount to face. The discount to face value is nothing but the interest rate charged at a nominal spread over the U.S. treasury bills Treasury BillsTreasury Bills (T-Bills) are investment vehicles that allow investors to lend money to the government..
For example, say the banker has an acceptance liability of $1,50,000 for the trade execution. The holder (exporter) to whom such assurance is provided can sell the instrument in the secondary market Secondary MarketA secondary market is a platform where investors can easily buy or sell securities once issued by the original issuer, be it a bank, corporation, or government entity. Also referred to as an aftermarket, it allows investors to trade securities freely without interference from those who issue them. at $1,45,000. This way, the liability of bankers does not change. Such trading in the secondary market proves the marketability of the instrument.
The concept of banker’s acceptance appears to be a blessing for parties that are unable to pay immediately and need goods and products from a seller on credit. When the banks take the liability to pay back if the party defaults, it becomes easier for the sellers to trust them and hence, the deal or transaction happens smoothly.
Listed below are some of the major advantages that this process brings along:
- The account holder (importer) against whose default the assurance is provided need not pay the amount in advance. The liability amount gets debited only on the due date of payment.
- The banker’s acceptance facilitates trade between the two unknown parties. In addition, it 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 the default of a country’s 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. The exporter is assured about its payment, and the importer is assured about the timely receipt of goods.
- The exporter is assured about its payment, and the importer is assured about the timely receipt of goods.
- Guarantees in payment promote the business.
The process of banker’s acceptance involves guarantees from the bank on behalf of its customers. As the deal involves financial promises to be kept for a future date, it is important to have some restrictions imposed on the parties taking up such services or consent. Hence, there are a few limitations or challenges associated with banker’s acceptance that one must know about before opting for such options.
Let us have a look at some of them in brief:
- The primary risk of a financial banker is the inability to pay the account holder. The banker has accepted the risk of defaultRisk Of DefaultDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.. The bank will have to honor the payment even if the account holder does not maintain sufficient funds on the payment date. That is the reason why all banks do not issue bankers’ acceptance.
- To hedgeHedgeHedge refers to an investment strategy that protects traders against potential losses due to unforeseen price fluctuations in an asset the banker’s risk, it may ask the importer to provide collateral security in the bank’s name.
- Even if the banker has performed the fundamental check, it still faces the liquidity risk from the importer.
Frequently Asked Questions (FAQs)
Yes, a banker’s acceptance is an asset. It is a type of short-term promissory note that represents a promise by a bank to pay a specified amount at a future date. Bankers’ acceptances are commonly used in international trade to facilitate the payment of goods and services.
Banker’s acceptance and commercial paper are both short-term financing instruments that are used by businesses to raise capital. However, a banker’s acceptance is a financial instrument that involves a bank accepting an obligation to pay a specified amount on a future date. At the same time, commercial paper is a short-term promissory note issued by a corporation.
No, a banker’s acceptance is different from a letter of credit. A banker’s acceptance is a short-term financing instrument that involves a bank accepting an obligation to pay a specified amount on a future date. On the other hand, a letter of credit is a financial instrument that a bank issues on behalf of a buyer to guarantee payment to a seller in a transaction.
This article has been a guide to what is Banker’s Acceptance. Here, we explain the concept along with its examples, characteristics, benefits, and risks. You may learn more about financing from the following articles: –