Banker’s Acceptance – How Does It Work?

A Banker’s Acceptance (BA) is a type of financial instrument that promises a future payment at a certain date from the bank. It is also known as a bill of exchange.

A banker’s acceptance is used as a payment instrument in international trade. It comes with additional features of being marketable security. Hence, it can also be used as an investment tool by investors.

Deeper Definition

A banker’s acceptance is a financial instrument issued by a bank rather than an individual or a business. It guarantees a future payment to the beneficiary at a specific date.

It is often used in international trade. It eliminates the trust deficit between counterparties in international trade. The risk of default in a banker’s acceptance reduces as it shifts from the applicant to the bank.

How Does a Banker’s Acceptance Work?

When two parties in an international trade contract agree on trade terms, they can decide the payment method through a banker’s acceptance. The importer approaches the bank to issue a banker’s acceptance in favor of the exporter.

The bank appraises the credit profile of the applicant. Once approved, the bank will issue a banker’s acceptance in favor of the exporter. The importer can then forward the BA to the exporter. The maturity date of the BA is set from 30 days to 180 days depending on the needs of the importer.

Once the exporter receives this financial instrument, it can proceed with the order manufacturing. At this time, the exporter can sell the BA for a discount in the secondary market to receive cash immediately. The buyer will not receive the payment before maturity.

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Once a bank issues a banker’s acceptance, the liability shifts from the applicant to the bank. Hence, a bank may require collateral in some cases to issue a banker’s acceptance. Once issued, the BA will have a credit rating similar to that of the issuing bank.

Example

Suppose a company Salwa Electronics in the UAE orders 100 pieces of air conditioners from a German Manufacturer Triple Star co. Both parties agree on the pricing for a total of $ 200,000 and the payment method of a banker’s acceptance.

Salwa electronics will approach a bank, say Emirates NBD. The Emirates NBD will appraise Salwa electronics for creditworthiness. Once approved will issue a banker’s acceptance draft of $ 200,000 that expires in 120 days. The bank will charge fees for issuing a BA.

Salwa electronics will now forward the BA to Triple star co. In Germany. After receiving a BA, the Triple star Co. Will start manufacturing. Triple star co. Will have the option of trading the BA at a discount for immediate cash, say for $190,000. The buyer can hold the BA till maturity to earn a profit of $10,000 or sell it to another buyer with a further discount. The cycle can continue until the maturity of the BA. The final beneficiary receives the face value i.e. $ 200,000.

Special Considerations with a Banker’s Acceptance

A banker’s acceptance can be used primarily as a mode of payment. It is more secured than bank checks or time drafts.

As a Payment Instrument

As we have seen in our example, it can be used as a payment instrument. Two parties in international trade can agree to use a banker’s acceptance as a payment method. The beneficiary is at a lower risk of default with a BA than other payment instruments such as checks.

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As an Investment Instrument

It is marketable security. As it is backed by the high credit rating of the issuing bank. An investor can invest in a BA at a discounted price and hold it till maturity to receive the face value. The difference between the discount price and the face value is the profit for the investor.

Advantages of Banker’s Acceptance

A banker’s acceptance provides several advantages to both parties in an international trade agreement:

  • The applicant can obtain the facility without collateral and paying up-front cash.
  • The beneficiary can reduce the risk of default as it is issued by a financial institute.
  • Banker’s acceptant can be used as marketable security to make profits.
  • It offers a secured and flexible payment option for both parties.
  • It can help both parties to expand the business beyond borders by reducing the trust deficit.

Disadvantages of Banker’s Acceptance

A banker’s acceptance can come with some limitations as well:

  • Applicants require a higher credit profile to obtain the facility as the risk of default moves to the issuing bank.
  • The bank remains at a default risk of the applicant.
  • Applicants may need additional collateral to secure the facility.
  • The beneficiary of this financial instrument still faces a risk of default, although lower than normal.

Conclusion

A banker’s acceptance is a marketable security that is used primarily as a payment instrument. The risk of default lies with the issuing bank rather than the applicant. The beneficiary can use it as an investment tool by trading it at a discount in the secondary market.

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