Updated July 12, 2023
What is a Banker’s Acceptance?
In international trade, the term “banker’s acceptance” refers to a short-term money market instrument that helps eliminate the payment risk, especially when the supplier and the buyer belong to different countries and don’t know each other that well.
Basically, it is a type of time draft that a business gets from a bank as an additional cushion to cover for counter-party risk. In other words, the bank promises on behalf of the importer to pay the exporter a given amount on a specific date by debiting the importer’s account. So, a banker’s acceptance is kin to a post-dated cheque from a bank. Still, there is a key difference between the two wherein a banker’s acceptance can be traded in the secondary market prior to its maturity.
How Does Banker’s Acceptance work?
Let us assume that an importer from country A entered into a sales transaction with an exporter from country B. The exporter is ready to ship the consignment and supply it to the port of the exporter’s country but is awaiting an assurance of payment. On the other hand, the importer is not sure whether the exporter will supply goods of appropriate quality and correct quantity after full payment. So, both supplier and buyer sense some transaction-related risks, which is where the banker’s acceptance comes into play.
The importer’s bank extends payment assurance to the exporter. Consequently, trade takes place between the two parties. In this case, the bank acts as the intermediary and so the importer can raise concern and ask the bank to hold the payment if the supplied good’s quality is not up to the mark or the quantity is not correct. In this way, It provides cover against counterparty risk for the exporter and financial support for the importer. If the transaction takes place as per agreed terms, the bank clears the payment on the due date and the bank charges a commission for this service.
A banker’s acceptance is considered to be eligible if the Fed accepts it as collateral at the discount window or if the bank is able to sell without any reserve requirement. However, it is to be noted that the Fed no more purchases banker’s acceptance, while the eligibility criteria around reserve requirements still hold good.
Banker’s Acceptance Rates
It is backed by a bank’s promise to pay and hence is considered to be a safe investment. These financial instruments are often traded at a discount to their face value. The discount rate is known as the banker’s acceptance rate and it is the market rate at which banker’s acceptance trade in the secondary market. It is seen as the return of investment for an investor would purchase the instrument today and hold it until the payment (or maturity) date.
Obtaining Banker’s Acceptance
- Any entity that intends to enter into a high-value transaction would get in touch with its banker for a banker’s acceptance. The entity would need to provide the details about the transaction including the amount of credit required.
- The bank would evaluate the credit history of the entity to assess its creditworthiness. If satisfied, the bank would accept the liability on the entity’s behalf.
Some of the major benefits are as follows:
- The importer doesn’t need to pay the transaction amount in advance as the payment actually gets debited only on the due date.
- It helps in building trust between two unknown parties and in the process facilitates trade between them.
- It assures the importer about the timely receipt of the consignment and the exporter about the payment.
- It acts as an additional hedge for the trade transaction.
Some of the major disadvantages are as follows:
- From the perspective of a bank, the major risk is the inability of the account holder to pay on the due date wherein the account holder fails to maintain adequate funds on the payment date.
- The account holder or importer may be asked by the bank to provide collateral securities to hedge the default risk.
- Despite all fundamental checks and assessments, the bank is still exposed to liquidity risk from the importer.
Some of the key takeaways of the article are:
- It is a financial instrument issued by a bank that promises payment on a specific later date.
- It is usually used in international trade wherein the importer’s bank guarantees payment to the exporter.
- Although it is quite similar to a post-dated bank cheque, there is a primary difference wherein a banker’s acceptance is traded on a secondary market and hence considered to be an investment tool.
- An investor can purchase a banker’s acceptance in the secondary market at a discounted price and hold it till its maturity (or payment date).
- The process of applying for a banker’s acceptance is similar to that of a short-term loan, where the borrower undergoes a thorough credit background check.
So, it can be seen that a banker’s acceptance is not only a useful tool for international trade between two unknown entities but also a very good investment option for interested investors. The businesses can use it to eliminate trade-related risks, while the investors can have it in their investment portfolio to counterbalance the high-risk securities.
This is a guide to Banker’s Acceptance. Here we also discuss the definitions, it’s working, Eligibility along with the benefits and disadvantages of banker’s acceptance. You may also have a look at the following articles to learn more –