Despite the rise in open account trading, letters of credit remain a key tool in the trade finance arena, protecting both the importer and the exporter from counterparty risk. However, letters of credit are complex to prepare and are frequently rejected with documentary discrepancies in the first instance. A solution to this is to outsource the processes relating to letters of credit. In this Business Briefing we review the difficulties associated with letters of credit and discuss the benefits which an outsourcing solution can provide.
Outsourcing
Outsourcing is a common concept in business. On the simplest level, outsourcing means asking another company to undertake certain operations rather than carrying them out in-house. Companies may decide to outsource operations for a number of reasons:
Economies of scale:
The outsourcing provider can usually achieve economies of scale by carrying out services for a number of clients and may therefore be able to offer the services more cheaply.
Skills:
Existing staff may lack the skills and knowledge required to carry out the operations effectively. Outsourcing offers an alternative to training or recruitment as a means of filling this gap.
Focus:
Outsourcing non-essential activities may allow companies to focus their attention on more strategic areas of the business.
What can be outsourced?
Activities that are outsourced are typically non-core activities. These range from technological solutions, which can be provided by ASPs on a rental basis rather than purchasing and implementing expensive systems in-house, to human resources departments.
In the treasury context, services which can be outsourced include risk management activities, cash management, accounting, netting systems and cash flow forecasting. Interestingly, another area which can be outsourced is the full range of activities relating to letters of credit (also known as documentary credits).
Letters of credit
The letter of credit is a method of payment which has been used in global trade for centuries to protect the interests of both the importer and the exporter. While letters of credit are less common than they used to be, due to the growth of trade on open account terms, letters of credit are still used in around 15% of world trade.
In a letter of credit transaction, the importer asks its bank to issue a letter of credit in favour of the exporter. The letter of credit is issued with a number of documentary conditions which must be met before the exporter can receive payment. Documents which must be presented by the importer vary from transaction to transaction, but typically include bills of lading, commercial invoices, insurance certificates and inspection certificates confirming the quality of the goods.
Once the importer’s bank has confirmed that the submitted documents meet the conditions of the letter of credit, payment is made or guaranteed by the bank of the importer. The importer is then able to collect the goods.
Letters of credit therefore offer both parties in a trade transaction a number of advantages. The importer is not obliged to pay for the goods until the specified conditions have been met, guarding against the delivery of faulty or incorrect goods. Meanwhile, the exporter is guaranteed payment as long as the conditions are met, which safeguards against the risk that the importer will claim the goods but fail to pay. In addition, exporters can use letters of credit to raise finance, while importers can build additional safeguards into the terms of the letter of credit by specifying delivery times and the level of quality required from the goods.
Obstacles
Letters of credit provide clear advantages for the importer and the exporter. However, the process is also associated with significant obstacles.
Letter of credit transaction
Rejected documentation
A large percentage of the documents submitted – estimated by some to be as high as 70% – fail to meet the required conditions. This may be for a number of reasons, including inconsistencies between documents, errors in the description of goods on the invoice or the late presentation of documents.
Once a letter of credit has been rejected, the process of recovering both payment and goods becomes more complicated. Documents can sometimes be amended to meet the requirements, but in practical terms it may not be possible to do this before the letter of credit has expired. Alternatively the importer may decide to pay despite the discrepancies, sacrificing the certainty that the goods are exactly what have been purchased. Another option is to give up the guarantee of payment by treating the transaction as a documentary collection – a far less attractive option for the exporter.
All of these solutions have disadvantages, meaning that the vast majority of letter of credit transactions are complicated, time consuming and potentially lacking in the security that they are designed to provide. Meanwhile, delays resulting from documentary discrepancies can be expensive as goods may have arrived at the destination port while the discrepancies are resolved, incurring storage fees and potentially becoming redundant in the case of seasonal goods.
Country-specific requirements
In addition, certain countries have more complicated requirements relating to the administration of documentary credit business. This is particularly the case in Africa and the Middle East. For example, some countries require a consular invoice to be issued, which must be presented to the importing country’s consul for legalisation. In certain cases it is also necessary to provide a certificate of origin notarised by the local chamber of commerce. From the point of view of the corporate, particularly when trading with counterparties in a wide range of countries, complying with the different practices can be time consuming and takes focus away from the company’s core business.
The outsourcing option
As an alternative, some companies choose to outsource the processes relating to letters of credit. This is an option which is available to both the importer and exporter. In an outsourcing arrangement, the chosen bank takes over the processing of letters of credit either partially or completely.
The specific tasks which the bank may take over vary depending on the nature of the agreement but can include one or more of the following:
Assistance with the preparation of tender conditions relating to payment processes and protection.
Preparation of sample letters of credit relevant to the client’s order.
Checking incoming letters of credit for discrepancies in their terms and conditions and ensuring that the terms and conditions match those of the commercial contract.
Undertaking correspondence with foreign banks regarding amendments, additions or explanations of the terms and conditions of letters of credit.
Monitoring the expiry dates of letters of credit.
Drawing up, correcting and gathering together documents for letters of credit and collections.
Obtaining document certifications and legalisations for letters of credit and collections.
Case study
ARI-Armaturen
Thomas Gössling
Commercial Director
ARI-Armaturen is a German engineering company based in Schloß Holte-Stukenbrock, near Bielefeld. The company – which is part of the Brechmann Group – develops and manufactures industrial valves used in building automation, shipbuilding, the chemical industry and other industrial processes. ARI-Armaturen sells its product range of industrial control, safety, check and shut-off valves to customers worldwide, in particular to Europe and Asia, but also to North and South America and Africa. The company employs over 600 people and posts a turnover of €100m.
ARI-Armaturen distributes the majority of its products through a worldwide network of distribution partners. In order to manage customer credit risk, the company typically takes out credit insurance for domestic and international transactions. If credit insurance is not – or only partly – available for a specific country and the deal size is significant, ARI-Armaturen will use documentary credits as a means of payment. This is, for example, the case with exports to Pakistan, India, China, Indonesia, Egypt or Iran.
Previously, the company employed a dedicated specialist to manage all documentary credit transactions. While it was beneficial to maintain this kind of expertise in-house, it also posed a number of problems according to Commercial Director Thomas Gössling:”With regard to the documentary credit business, only one person in-house had the necessary expertise, which presented us with the problem of sickness and holiday cover. Due to our increase in exports and a growing number of documentary credit transactions, we were faced with the question of how to maintain this specialist knowledge. We also needed to ensure that the information was kept up-to-date, considering the large number of different regulations in each country.”
Several financial institutions had matched these risk management concerns by offering documentary credit outsourcing services to the company. As Thomas Gössling explains, ARI-Armaturen considered outsourcing the documentary business for several reasons: “Firstly, we would no longer be dependent on maintaining these resources internally. Secondly, we would free up our sales team so they could sell, rather than spend their time drafting and processing documents, which is very time consuming and not part of our core business. The necessary level of expertise which must be maintained internally can also be provided more effectively by a third-party specialist.”
Gössling discussed documentary credit outsourcing with a number of banks. The company obtained several quotes and trialled the services offered. Eventually, ARI-Armaturen awarded the outsourcing contract to Commerzbank by choosing the bank’s ‘Value for Doc’ offering.
“Commerzbank is our main relationship bank for the international business and the bank has already processed letters of credit for us in the past”, says Gössling. “We were pleased with their service. In addition to the specialist knowledge and the existing good personal relationship, Commerzbank also compared favourably in terms of cost-effectiveness.”
The bank now manages all documentary business processes on behalf of ARI-Armaturen. With hindsight, Thomas Gössling concludes: “The existing cost advantages of outsourcing are difficult to measure, but there are clear benefits in the level of service provision and ultimately customer satisfaction. We are convinced that we have made the right decision. We would do it again and we would also do it again with Commerzbank.”
In addition, banks have increasingly collaborated with logistics providers to enable them to provide a wider range of trade services. These can include:
Logistics consulting.
Transport plans and transport cost calculation.
Export logistics.
Handling of spare parts and returns processing.
Tracking and tracing.
Freight management and tracking.
Warehousing and distribution.
Companies can therefore choose to outsource more than simply the processes relating to letters of credit.
The recent focus on supply chain management has meant that banks and suppliers are increasingly looking at ways of increasing efficiencies within the trade processes by considering these processes on a holistic level. The growing tendency of banks to provide logistical services is one way in which corporates can address efficiency within their financial and physical supply chains simultaneously.
Benefits for customers
Corporates who outsource their documentary business using these type of value added services may expect to achieve cost savings in several areas. For example, depending on the terms of the agreement, the high staff and overhead costs of processing internally may be replaced with proportional costs relating to the number of transactions carried out. By outsourcing the processes surrounding letters of credit, the company will only need to pay for the exact services used.
Cost savings can also be achieved as a result of the reduced resources needed to manage letters of credit compared to carrying these processes out in-house. As well as cost savings this can enable companies to focus on their core competencies.
A higher level of reliability and efficiency is another benefit which is associated with outsourced letter of credit processes. Services such as checking documentation for discrepancies can ensure that the letter of credit will not be rejected as a result of such discrepancies, reducing the instances where payments are delayed or cancelled. As a result, it is easier to forecast the company’s cash flows relating to these transactions, which optimises the company’s ability to manage interest and liquidity. This can also result in cost savings as discrepancy fees and additional costs relating to the delayed delivery of goods can be avoided.
Outsourcing the processes relating to letters of credit can therefore remove many of the obstacles associated with this trading instrument while allowing corporates to retain the key benefits. In other words, importers can ensure that the goods they are purchasing meet their requirements before payment is made, while exporters are protected from the risk of non-payment.
Conclusion
With up to 70% of letters of credit rejected in the first instance, the delays, complications and costs associated with this trading instrument are significant. As a result, global trade has moved away from letters of credit in recent years, favouring open account terms instead. However, the security associated with letters of credit means that this is still a key payment method in many markets.
Outsourcing the processes associated with letters of credit can provide a solution to many of the drawbacks associated with letters of credit. Meanwhile, the provision of additional value-added services in the area of logistics can provide corporates with a broader type of solution and enable them to address their supply chain efficiencies more comprehensively.
Commerzbank/a major integrated bank.
Since taking over Eurohypo, Europe’s largest institution specializing in financing real-estate and public-sector projects, Commerzbank has been Germany’s second-largest bank and one of the leading banks in Europe. Its consolidated balancesheet total stands at €608 billion. Roughly 36,000 employees, 8,725 of them active outside Germany, look after more than 8 million customers worldwide.
Commerzbank sees itself as an efficient provider of financial services for private and business customers as well as for small to medium-sized companies (Mittelstand), but it also serves numerous major corporates and multinationals. For each of its core target groups, it aims to be the ‘best bank’.
Commerzbank is unreservedly committed to its home market, Germany. The group’s more than 1,000 branch network is spread throughout the country. Its corporate business also sees West, Middle and Eastern Europe as its core market. In both the USA and Asia, the Bank is active at all the major economic centers. In total, Commerzbank is represented in more than 40 countries with its own offices.
Commerzbank’s full service for your documentary foreign business offers you tailormade solutions.
For further information please contact Jasmin Maraslioglu at Commerzbank AG
