BOARD OF GOVERNORS
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 20551
DIVISION OF BANKING
SUPERVISION AND REGULATION
SR 95-20 (SUP)
March 30, 1995
TO THE OFFICER IN CHARGE OF SUPERVISION
AT EACH FEDERAL RESERVE BANK
SUBJECT: Financial Standby Letters of Credit and Performance Standby Letters of Credit.
This SR letter is being issued to clarify the distinction, for risk-based capital purposes, between a financial standby letter of credit and a performance standby letter of credit. The characteristics and distinguishing features of these two types of letters of credit that are set forth in this letter have been determined in consultation with the other federal banking agencies.
The risk-based capital guidelines issued by the Federal Reserve describe a financial standby letter of credit as an irrevocable undertaking by a banking organization to guarantee repayment of a financial obligation. This type of guarantee is considered a direct credit substitute and is converted to an on-balance sheet credit equivalent amount at 100 percent. A performance standby letter of credit is an irrevocable undertaking by the organization to make payment in the event the customer fails to perform a nonfinancial contractual obligation. This type of letter of credit is considered a transaction-related contingency and is converted at 50 percent. Financial standby letters of credit have a higher conversion factor in large part because, unlike performance standby letters of credit, they tend to be drawn down only when the account party's financial condition has deteriorated. The vast majority of standby letters of credit a bank issues are considered, for risk-based capital purposes, to be financial standby letters of credit.
The determining characteristic of whether a standby letter of credit is performance or financial is the contractual obligation that triggers payment. Where the event that triggers payment is financial, such as a failure to pay money, the standby letter of credit should be classified as financial. Where the event that triggers payment is performance-related, such as a failure to ship a product or provide a service, the standby letter of credit should be classified as performance.
A standby letter of credit guaranteeing the performance of a contractual obligation to pay money is viewed as a financial letter of credit. For example, a standby letter of credit backing a purchaser's contractual obligation to pay for delivered goods is a financial guarantee backing the purchaser's credit standing for the sale. It would not be viewed as a performance letter of credit guaranteeing the purchaser's performance to make payment under the contract.
A failure to perform a contractual obligation involving the payment of money can arise in a variety of situations, for example, failure to pay insurance premiums or deductibles, failure to pay insurance claims, failure to pay worker's compensation obligations, or failure to pay for (or arrange) cleanup in the event the account party's operations cause environmental damage. In each instance the triggering event is the failure to pay money under a contractual obligation. A standby letter of credit guaranteeing payment in the event the account party fails to perform any of these contractual financial obligations, or other circumstances, should be treated as a financial standby letter of credit and converted to an on-balance-sheet credit equivalent amount at 100 percent.
If you have any questions concerning this letter, please contact Norah Barger (202/452-2402) or Barbara Bouchard (202/452-3072).
Stephen C. Schemering
SR letters | 1995