An ongoing study of international finance practices, initiated in 1980 by the Thunderbird International Trade & Finance Center, reveals that trade finance - specifically, the use of "confirmed letters of credit" or "letter of credit" (LC) - has a much lower incidence of losses, defaults, reschedulings, or restructurings than other normal term international loans. This lower incidence of problems is true whether loans are made to the government or to the private sector.
The study's criteria for defining a loss assume that the bank must have appropriate operational capabilities or professionals properly trained to perform the transaction. The bank also must have the ability to analyze country risk as well as foreign bank risk. If the bank is unable to meet these performance assumptions, poor credit decisions by unqualified lending officers lead to losses on letters of credit.
The hypothesis tested in Thunderbird's study is the following: As a credit instrument, the confirmed LC is a safer instrument with a lower loss record and fewer restructurings than other international commercial loans, particularly term loans. The implication is that commercial banks whose international lending consists of trade finance - in particular letters of credit - have a safer or healthier international portfolio than banks involved in other types of international lending activities. Since a large percentage of bank lending to Asia consists of LCs, the impact of the Asia financial crisis on banks' performance and lending there is expected to be limited.
Traditional View of Trade Finance
The foregoing hypothesis - that trade finance is safer - is based on the argument that a country will not default on trade finance because this would result in that country not being able to import required products to support domestic economic activity. Cut off from imports that are required to generate exports in support of hard currency earnings, the country would rather quickly experience a slowdown in economic growth, debt servicing problems, and perhaps political disruptive effects. So there is an association between preventing defaults or loan losses on trade credits with that immediate need to support critical consumption or productive domestic economic activity.
In contrast, normal international loans are associated with longer-term economic development. A restructuring or renegotiation of a term international loan is not likely to cause the same intensity of immediate hardship to an economy; instead, the hardship is likely to be felt over a longer period of time. This is not to say that normal international loans are not vital to an economy. They potentially do not have the same immediate negative consequences on the economy if there was a default and restructuring of short-term trade finance instruments, such as an LC.
A distinction also needs to be made between short-term borrowing and trade finance. The maturity of the loan is not solely an indicator of safety for a bank. Short-term loans often are a substitute for term borrowing when interest rates are high or creditworthiness of the borrower is deteriorating. Since a short-term loan may not be related to the delivery of a product, it has no defined repayment characteristics, as is the case with an LC.
Therefore, these differences-shorter maturity and relationship to more vital or immediate needs (survival) of the country-are the basis for the current argument of reduced risk associated with trade finance compared to international term lending. It replaces the traditional perception that trade finance loans are less risky because they are more immediately self-liquidating once the goods are shipped and received. This perspective is no longer valid and increasingly very much removed from actual practice today as explained later in this article.
The following is a review of the data confirming the strong performance of letters of …