BF430 LECTURE 5-BANKER’S ACCEPTANCE (BA)

Lecture outline;

• Definition
• Steps/Sequence of BA
• Characteristics of BA
• Advantages of BA & its risk
• BA verses factoring

INTRODUCTION

- Bankers acceptances is a means of providing finance for international trade and creating a
unique financial instrument that is attractive to money market investors. It facilitates and
expands the sources of credits beyond a commercial bank.
- A banker’s acceptance is a time draft drawn by one party (the drawer) on a bank (the
drawee) and accepted by the bank as the bank’s commitment to pay a third party (the
payee) a stated sum on a specified future date. The bank promises to pay the draft at
maturity. The bank creating an acceptance becomes primarily liable for the payment on
the maturity date.
- Through the bankers’ acceptance banks can provide credit to their customers without
using the bank’s own funds. This is done by creating a negotiable instrument with a
specified maturity date which can be sold at a discount to investors.
- The bank stamps “accepted” across the draft with authorized signatures.
- BA is a negotiable instrument or time draft drawn on and accepted by a bank. Before
acceptance the draft is not an obligation of the bank it is merely an order by the drawer
to the bank to pay a specified sum of money on a specific date to a named person or to
the bearer of the draft. Upon acceptance the draft becomes liability of the bank, The
company’s bank stamps the Note “Accepted” and charges the company a stamping fee.

Illustration;
Suppose the bank receives a 6 months’ draft valued at K100,000 for an exporter, and it
charges a commission of 1.5% p.a, and the discount rate in the market is 7% p.a. How
much will the exporter receive now?
Face amount of acceptance K100,000
Less 1.5% p.a. commission for 6 months - 750

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 Amount received by exporter in 6 months K 99,250
Less 7% p.a. discount rate for 6 months - 3,500
Amount received by exporter at once K95,750
– Note-Exporter may discount the acceptance note in order to receive the funds up-front.

STEPS INVOLVED IN BANKER’S ACCEPTANCES;

First, the US importer places a purchase order for goods. The importer asks its bank to
issue a letter of credit (L/C) on its behalf. A letter of credit represents a commitment by
that bank to back the payment owed to the foreign exporter.

- The letter of credit is a document issued by a bank that guarantees the payment of
the importer's draft for a specified amount and time. Thus, the exporter can rely on
the bank's credit rather than the importer's.
- The exporter presents the shipping documents and the letter of credit to his domestic
bank, which pays for the letter of credit at a discount, because the exporter's bank
won't receive the money from the importer's bank until later.
- The exporter's domestic bank then sends a time draft to the importer's bank, which
then stamps it "accepted" and, thus, converting the time draft into a banker’s
acceptance.
- This negotiable instrument is backed by the importer's promise to pay, the imported
goods, and the bank's guarantee of payment.
In most cases, bankers’ acceptances are used in the import or export of goods.
However, in some cases, it may involve trading within the same country.
In other instances, a bankers acceptance, which in this case is termed a third-country
acceptance, is created to ship between countries where neither the importer nor the
exporter is located.

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CREATION OF BANKER’S ACCEPTANCE.

CHARACTERISTICS OF BANKER’S ACCEPTANCE

a) Credit Quality
An acceptance’s credit quality depends on the method by which the bank acquired the
acceptance and the acceptance’s terms. For an accepting bank, the credit quality is that of
the customer whose transaction the bank is financing.
The credit quality of a bankers’ acceptance may differ from a direct loan depending on
the terms and conditions of the two instruments. When the bank purchases an acceptance
in the market, the credit quality is that of the “accepting” bank whose acceptance the bank
purchases.
Credit quality is also enhanced by the fact that the holder of a bankers’ acceptance has
secondary recourse to the account party (importer/buyer) in the event the accepting bank
defaults.
b) Marketability
Bankers’ acceptances are marketable, short-term investment instruments which are traded
actively by banks, brokers, and other institutional investors. Many institutional investors
buy and sell bankers’ acceptances for their own accounts and for various funds they have
established for their customers.
Generally, local investors do not demand the high yields of institutional investors. This
increases the bank’s acceptance fee when dealing with local investors. Bankers’
acceptance rates are based on markets which may move rapidly in a very short time.

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 It is crucial that rates on acceptance financing are available on a timely basis because
these instruments have become increasingly volatile. For example, a quote made at 9:30
a.m. may be well off the market at 10:30 a.m. If rates have moved up significantly in that
hour, the bank may lose its entire acceptance commission as the funding cost rises. If
rates fall during that hour, another bank will almost certainly get the business by lowering
its quotation.
c) Liquidity
Bankers’ acceptances are often created to mature in six months or less. Banks can
purchase, discount, and sell the acceptances of other banks as short-term, money-market
assets (with low risk). Should a bank need to obtain funds, the bankers’ acceptances can
readily be sold at a predictable price as long as credit quality has not changed.

ADVANTAGES OF BANKER’S ACCEPTANCES

1) Smaller companies gain access to lower rates in the money market.

2) Bank earns a stamping fee to offset the loss of interest income on their traditional
lending activities.
3) The BA facility is “carved out” of the borrower’s line of credit – thus risk to the bank
is identical to lending under an operating line of credit.
4) Bank guarantees payment of the Draft/Note at maturity – provides confidence to the
market.
5) Banker’s acceptance can be sold at a lower discount than trade bills.

6) In terms of costs, acceptance credits cost is fixed, allowing for easier budgeting. The
company can assess the cost of its acceptance finance facility with more certainty
because costs are fixed over the life of a bill.

7) Banker’s acceptance/Acceptance credit may cost less than an overdraft at times of

rising interest rates. There is always a possibility of cost saving to a customer in the
use of the acceptance finance because the rate of discount on the bank bills in the
Discount Market might be lower than the interest rate on a bank loan or overdraft,
which are related to the bank base rate or the interbank lending rate.

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 The rationale for this is that the interest rate on a discounted bill is fixed for the life of
a bill, whilst loans or overdrafts are likely to have their interest rates changed, the
worst being when they increase.

Thus it would be more costly to maintain an overdraft or a short-term loan than to

have an Acceptance finance facility. Unlike an overdraft, the credit is guaranteed for
the length of the agreement. Acceptance finance provides companies with an
alternative source of finance to a Bank Overdraft, with the money being obtained
from a source outside the bank.

8) Banker’s acceptances have low credit risk because they are backed by the importer,
the importer's bank, and the imported goods. Hence, BAs offer slightly higher yields
than Treasuries of the same terms.

9) The amount of credit is promised to a customer for a stated period of time.

Bank services relating to BA for the corporate client.

Some of the services that bankers can provide to the corporate in line with this facility
include:

1. Advisory services with regard to how the corporate client can go about using the
facility as a short term funding alternative.

2. Facilitating the facility by way of originating and discounting the bills on behalf of
the clients.

Acceptance finance services have taken a long term perspective in which cash financial
houses are involved in arranging finance under long term loans for real estate, vehicle and
asset financing.

Major investors of these money market instruments (BA) naturally include money market
mutual funds, and municipalities. However, as other forms of financing have become
available, the secondary market for BAs has declined considerably.

What a bank charges for a BA depends not only on its own fees and commissions for creating
the BA, but is also commensurate with general market yields of other money market
instruments.

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RISKS ASSOCIATED WITH BANKERS’ ACCEPTANCES

The risks associated with bankers’ acceptances are transaction, compliance, credit,
liquidity, foreign currency translation, and reputation. These risks are discussed more
fully in the following paragraphs.

1. Transaction Risk

Transaction risk is the current and prospective risk to earnings and capital arising from fraud,
error, and the inability to deliver products or services, maintain a competitive position, and
manage information. Banks should work closely with borrowers seeking bankers’
acceptance financing to ensure that the borrower fully understands the supporting
documentation and timely processing requirements related to this type of financing.
The basic documentation for a bankers’ acceptance consists of:

- A bankers’ acceptance credit agreement which contains the borrower’s promise to

repay the bank when the acceptance matures.
- A “purpose statement” or letter from the borrower that describes the underlying
trade transaction being financed, certifies that no other financing is outstanding,
and specifies that the transaction has not been refinanced.

2. Compliance Risk

Compliance risk is the current and prospective risk to earnings or capital arising from
violation of, or non-conformance with laws, rules, regulations, prescribed practices, internal
policies and procedures, or ethical standards.

Compliance risk also arises in situations where the laws or rules governing certain bank
products or activities of the bank’s clients may be ambiguous or untested. This risk
exposes the institution to fines, civil money penalties, payment of damages, and the
voiding of contracts.

Compliance risk can lead to diminished reputation, reduced franchise value, limited business
opportunities, reduced expansion potential, and lack of contract enforceability.

The major compliance risk associated with bankers’ acceptance financing relates to
creating ineligible bankers’ acceptances but treating them as if they were eligible for

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discount. If this occurs, the Central Bank will generally impose a retroactive reserve
requirement on the accepting bank.

Eligible Bankers Acceptances

For instance, United States banks sometimes borrow from the Federal Reserve Bank, but to
do so, the bank has to deposit collateral in its account at the Federal Reserve Bank. A
banker’s acceptance can be used for collateral if it is an eligible bankers acceptance, which
has certain characteristics.

The eligibility criteria include the requirements that the acceptance:

(1) it is for a trade transaction involving exporting and importing (including transactions
between foreign countries), domestic or foreign storage of readily marketable commodities,
or domestic shipment of goods; and

(2) have a maturity of 6 months or less. BAs that grow out of the storage of commodities must
be secured at the time of acceptance by a warehouse receipt or other document conveying or
securing title. The Federal Reserve does, however, impose limits on the number of eligible
BA that can be issued by a bank.

(3) denominated in dollar (domestic) currency

If the bank has created a bankers’ acceptance based upon accurate information provided by
the borrower in the purpose statement, only to learn later that it erroneously considered the
transaction eligible, the bank will not be able to collect compensation from the customer to
cover the reserves.

Compliance with the legal lending limit must be considered. When a bank discounts or holds
its own bankers’ acceptances, they are converted to a loan and included in the legal lending
limit. Purchased bankers’ acceptances are exempt.

3. Credit Risk

Credit risk is the current and prospective risk to earnings or capital arising from an
obligator’s failure to meet the terms of any contract with the bank or otherwise to perform as
agreed.

Credit risk is found in all activities where success depends on counterparty, issuer, or
borrower performance.

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It arises any time bank funds are extended, committed, invested, or otherwise exposed
through actual or implied contractual agreements, whether reflected on or off the balance
sheet.

Bankers’ acceptances contain credit risk not only for the bank creating the acceptance,
but also for the exporter, for banks purchasing another bank’s acceptances, and for
other investors (such as money market mutual funds, trust departments, state and local
governments, insurance companies, pension funds, corporations, and commercial
banks) who buy bankers’ acceptances.

The principal credit risk of this instrument is that the importer will be unable to make
payment at maturity of the bankers’ acceptance — leaving the accepting bank responsible to
make payment. For acceptances purchased in the market, credit risk is somewhat mitigated
because bankers’ acceptances are considered to be “two-name paper,” which means that the
importer is secondarily liable on the instrument. In addition, the instrument is a contingent
obligation of the drawer (exporter).

In other words, the exporter (drawer) is contingently liable if the importer does not pay. The
acceptance is also an obligation of any other institutions that have endorsed it. That is,
“holders in due course” that have bought and sold the acceptance in the market.

4. Liquidity Risk

Liquidity risk is the current and prospective risk to earnings or capital arising from a bank’s
inability to meet its obligations when they come due without incurring unacceptable losses.
Liquidity risk includes the inability to manage unplanned decreases or changes in funding
sources.

Liquidity risk also arises from the failure to recognize or address changes in market
conditions that affect the ability to liquidate assets quickly and with minimal loss in
value. Partly because the maturities of most bankers’ acceptances are short, the market
generally views acceptances as safe and liquid. The fact that “name” banks dominate
acceptance financing also limits liquidity risk.

Liquidity risk will be greater if the accepting bank is lower rated, is not a “name” or
“prime” institution, or if the instrument is not eligible for Federal Reserve discount.

5. Foreign Currency Translation Risk

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Foreign currency translation risk is the current and prospective risk to capital or earnings
arising from the conversion of a bank’s financial statements from one currency into another.
It refers to the variability in accounting values for a bank’s equity accounts that result from
variations in exchange rates which are used in translating carrying values and income streams
in foreign currencies to the Zambian Kwacha (ZMW). Market-making and position-taking in
foreign currencies should be captured under price risk.

Bankers’ acceptances created in foreign currencies, i.e., not in Kwacha, are subject to
foreign exchange dealing and position-taking risk. The risk to earnings or capital is
from movement of foreign exchange rates versus the Kwacha.

6. Reputation Risk

Reputation risk is the current and prospective impact on earnings and capital arising from
negative public opinion. This affects the institution’s ability to establish new relationships or
services or to continue servicing existing relationships.

This risk may expose the institution to litigation, financial loss, or a decline in its customer
base. Reputation risk exposure is present throughout the organization and includes the
responsibility to exercise an abundance of caution in dealing with customers and the
community.

In bankers’ acceptance activities, a bank lends its good name to a transaction.

Therefore, it is important that the customer requesting the bankers’ acceptance
transaction have a sound reputation. As for the banks, bankers’ acceptances are
generally created only by reputable, well-known banks with a good credit standing, thus
making such instruments safe.

FACTORING SERVICES

Factoring is a financial transaction whereby a business sells its accounts receivable (i.e.,
invoices) to a third party (called a factor) at a discount in exchange for immediate money
with which to finance continued business.

Factoring

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• The three parties directly involved are: the one who sells the receivable, the debtor, and
the factor.
• The receivable is essentially a financial asset associated with the debtor’s liability to pay
money owed to the seller (usually for work performed or goods sold).
• The seller then sells one or more of its invoices (the receivables) at a discount to the third
party, the specialized financial organization (the factor), to obtain cash.
• The sale of the receivables essentially transfers ownership of the receivables to the factor,
indicating the factor obtains all of the rights and risks associated with the receivables.
• Accordingly, the factor obtains the right to receive the payments made by the debtor for
the invoice amount and must bear the loss if the debtor does not pay the invoice amount.
• Usually, the account debtor is notified of the sale of the receivable, and the factor bills the
debtor and makes all collections.
• In factoring, a financial institution (factor) buys the accounts receivable of a company
(Client) and pays up to 80% (rarely up to 90%) of the amount immediately on agreement.
• Collection of debt from the customer is done either by the factor or the client depending
upon the type of factoring.
• A major advantage of Factoring is that it is a form of off balance sheet financing.

Recourse Factoring

• Under a recourse factoring arrangement, factor has recourse to the client if the
receivables factored turns out to be irrecoverable.
• Factor does not assume credit risks associated with the receivables.

Non-Recourse Factoring

• Under a non-recourse factoring arrangement, factor does not have recourse to the
client if the receivables factored turns out to be irrecoverable.
• The Factor bears the loss arising out of irrecoverable receivables.
• The loss arising out of the irrecoverable receivables is borne by him, as a
compensation for which he charges a higher commission. The Factor charges higher
commission called del credere commission as a compensation for the said loss

Factoring differs from a bank loan in three main ways.

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- First, the emphasis is on the value of the receivables (essentially a financial asset), not the
firm’s credit worthiness.
- Secondly, factoring is not a loan – it is the purchase of a financial asset (the receivable).
- Finally, a bank loan involves two parties whereas factoring involves three.

BILL DISCOUNTING

- Bill discounting is a fund based service provided by a bank and finance companies.
- An endorsed bill of exchange is handed over for ready money.
- The margin between the ready money and the face value of the bill is called ‘Discounting
of Bills’.
- Suppose a seller sells goods or merchandise to a buyer. In most cases, the buyer would
like to purchase on credit. The seller draws a Bill of exchange of a given maturity on the
buyer. The seller has now assumed the role of a creditor and is called the drawer of the
Bill. The buyer who is the debtor, is called the drawee. The seller then sends the bill to
the buyer who acknowledges it by writing his acceptance on the bill.
- Banks are also involved in discounting of bills. They discount only clear and reputable
bills. Discounting of bills is one of the methods of advances made by the banks. The
working capital of the corporate sector is mainly provided by banks through cash credit,
overdrafts, and discounting of the commercial bills.
- The bills are used for financing a deal in goods that take same time to complete. The bill
of exchange reveals the liability to make the payment on a fixed date when the goods are
bought on mercantile basis.
- The bills of exchange will be treated as negotiable instrument. They are drawn by the
seller on the buyer for the value of the goods delivered by him. These bills are called
trade bills. If the trade bills are accepted by the commercial banks, they are known as
commercial bills.
- If the seller provides some time for the payment of the bill payable at a future date, it is
known as usance bill. If the seller party is in need of finance, he may approach the bank
for discount of the bill.
- The commercial banks generally finance the business community through bill discounting
method. The banks can rediscount the bills in the discount market. A bill is always drawn
by the creditor on the debtor. It may be payable at sight or after the expiry of a certain
specified time.

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- There will be 3 days of grace period for a bill. The discount amount on the trade bill
becomes income to the commercial banks. It is an income generating activity for the
banks. Banks are required to select the borrowers after careful examination of their credit
worthiness and reputation.

- Factoring versus Bill Discounting

• Bill discounting is always with recourse while factoring can be either with recourse or
without recourse.
• Bill Discounting does not involve assignment of debt as is the case with factoring.

Issuance of Bankers’ Acceptances - Illustration

By far the largest proportion of bankers’ acceptances are created as a result of
international trade transactions. Following is an example of a bankers’ acceptance created
by a trade transaction. See the diagram below;
NE Trading is interested in purchasing 20 personal computers from Tokyo Tech
(1). Since the two companies have never done business with each other, Tokyo Tech will
require that NE Trading obtain a letter of credit. The letter of credit places the bank in the
intermediary role to facilitate the completion of the transaction. NE Trading takes the
computer purchase contract to its bank, FNB, and makes out an application for a letter of
credit
(2). FNB opens the letter of credit and sends the original and a copy to Tokyo Tech’s
bank, Suki Bank
(3). Suki Bank staff examines the letter of credit for validity and, upon verifying such,
notifies Tokyo Tech. Since Tokyo Tech is not familiar with FNB, it pays a fee to have
Suki Bank confirm the letter of credit
(4), which makes Suki Bank liable should NE Trading and FNB fail to perform under the
letter of credit. Tokyo Tech ships the goods
(5) and presents the shipping documents to Suki Bank
(6) to have them negotiated.
Along with the documents presented is a draft, drawn on FNB, for the selling price of the
goods. (A draft is an unconditional written order signed by one person directing another
person to pay a certain sum of money on demand or at a definite time to a third person or
to the bearer.) In our example we are using a time draft. The terms of the draft are

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negotiated at the time the terms of the letter of credit are determined. Suki Bank examines
the documents presented and, if they meet the terms and conditions of the letter of credit,
it sends the draft and the shipping documents to FNB
(7). Had it been a sight draft, Suki Bank would have effected payment of the invoice
amount to Tokyo Tech and mailed the draft and documents requesting FNB to credit its
account for the amount paid. FNB compares the documents with the letter of credit to
ensure that they meet the terms and conditions stipulated in the letter of credit. If all is in
order FNB furnishes NE Trading the documents
(8), an advice of amount paid and “accepts” the draft
(9). The term “accepted” is stamped on the face of the draft, thus creating a bankers’
acceptance. If NE Trading was a large corporation with a market name, it could accept
the draft itself without requiring FNB to accept. An acceptance created by a corporation is
known as a “trade” acceptance.
By accepting the draft, FNB has accepted Tokyo Tech’s demand for payment and
commits to pay Tokyo Tech in 90 days. The accepted draft is then sent to Tokyo Tech
(through Suki Bank)
(10). As part of the letter of credit agreement NE Trading is required to pay FNB within
the 90 days (11). The funds are then used by FNB to pay Tokyo Tech
(12,13). Tokyo Tech may hold the acceptance until maturity and present it to FNB for
payment, or it may obtain immediate cash by selling the acceptance to an investor,
perhaps to FNB or Suki Bank. In the latter case, Suki Bank would then present the
acceptance at maturity to FNB for repayment.
(The numbers in parentheses refer to steps in the appendix’s diagram):

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