Characteristics of Unconditional Letters of Credit

 
Unconditional Letters of Credit are often posted by insurance and reinsurance companies (and certain corporate obligors) as collateral for contingent future payment obligations. Where a future obligation is not yet crystalized, Letters of Credit are a flexible method for an obligor to provide future credit assurance without a current balance sheet impact.
An Unconditional Letter of Credit creates an irrevocable right for the named Beneficiary to receive payment from the Issuing Bank for a pre-specified amount, upon demand and without any other conditions. This claim is a senior unsecured obligation of the Issuing Bank on par with its senior debt or deposits. A Letter of Credit held by a lending institution as Beneficiary thus provides the same unrestricted payment rights as holding a demand deposit at the Issuing Bank – that is, the right to require the Issuing Bank to make payment of the Letter of Credit face amount at any time and for any reason. Unlike a guarantee, the terms of an unconditional Letter of Credit held by the lending institution do not require the Beneficiary to demonstrate a default or non-performance under the secured obligation in order to claim payment from the Issuing Bank. The Beneficiary need only deliver a draft notice specifying the Letter of Credit and draw amount. Absent evidence of forgery or fraud, an Issuing Bank must promptly pay the sight draft amount to the named Letter of Credit Beneficiary.
If a Letter of Credit is drawn, the Issuing Bank generally has a contractual right, under a separate credit agreement, to seek reimbursement from the party requesting the Letter of Credit (i.e., the pledgor). However, under the long-standing laws and regulations governing Letters of Credit, such a reimbursement claim does not excuse or allow for delay in the Issuing Bank’s payment to the Beneficiary of the requested Letter of Credit draw amount. Since the Letter of Credit, when issued, is irrevocable and unconditional, the separate terms between the Issuing Bank and the party requesting the Letter of Credit customarily require that all accrued fees and other due amounts are fully paid to the Issuing Bank, as a pre-condition before the Letter of Credit is issued.
 

Regulatory Background

1. Section 2 of Credit Risk Mitigation (Chapter 4, Title II, Part Three) specifies the items which qualify as eligible collateral under Funded Credit Protection, and Article 197(1) under that section lists items that are “eligible collateral under all approaches and methods “.
2. While that section does not mention Letters of Credit specifically, Article 197(1)(a) does specifically include:
(a) cash on deposit with, or cash assimilated instruments held by, the lending institution
”Cash assimilated instrument” is defined in point (60) of Article 4, as follows:
“ cash assimilated instrument means a certificate of deposit, a bond, including a covered bond, or any other non-subordinated instrument, which has been issued by an institution, for which the institution has already received full payment and which shall be unconditionally reimbursed by the institution at its nominal value;”

3. These definitions indicate the following conditions to be satisfied for a lending institution to treat a posted item as a “cash-assimilated instrument” eligible for inclusion as Funded Credit Protection against an outstanding exposure position under Article 197(1)(a):
(i) the posted instrument is held by the lending institution;
(ii) the posted instrument is a non-subordinated payment obligation of the Issuing Bank;
(iii) the Issuing Bank has received full payment for it (no funding pre-conditions to repayment);
(iv) the Issuing Bank is unconditionally obligated to pay the nominal value of the instrument (no performance pre-conditions to repayment).

4. For clarity, this question relates only to Unconditional Letters of Credit that are held directly by a lending institution as Beneficiary.
- The Regulations distinguish the treatment of directly-held cash assimilated instruments from similar instruments held indirectly through a third party.
- Article 212 (governing “other funded credit protection”) also refers to “cash on deposit with, or cash assimilated instruments” - but with respect to cash/instruments held by a third party rather than posted directly to the bank. Article 212 specifies that such indirectly posted instruments instead should be treated as a form of guarantee by the third party under to Article 232(1),
- A practical reason for this difference in characterization versus Article 197(a) may be that a third party holding the posted instrument as collateral typically would need to first demonstrate a default under the supported obligation (as under a financial guarantee) before it could act in its fiduciary role to convert the instrument to cash.