Banker’s Acceptance – Meaning, Advantages and its Disadvantages

In the previous articles, we have discussed some of the financial instruments which are commonly used in the money markets. However, most instruments are used for the purpose of domestic transactions. There is one money market instrument that stands out since it is widely used in order to finance international trade. In this article, we will have a closer look at what banker’s acceptance is as well as how it is used in the money markets.

What is Bankers Acceptance?

A banker’s acceptance is born out of the need for financing international trade. In terms of local trade, the seller often gives credit to the buyer. However, in the case of international trade, extending long-term credit could lead to significant bad debts. Hence, a lot of the sellers try to avoid extending credit to buyers. This creates a problem for buyers who may not have the ready cash to pay for the shipment.

This problem is often resolved by an intermediary bank which is usually the buyer’s bank. The seller does not believe in the creditworthiness of the buyer but they do believe in the creditworthiness of an institution such as the bank. Hence, they agree to accept payment at a later date if the bank is guaranteeing it.

Hence, a banker’s acceptance is a tool for substituting the creditworthiness of the buyer with the creditworthiness of the bank. Now, in most cases, sellers do not want to wait for a long period to get their money. Hence, they often ask the bank to pay them immediately after deducting a small percentage as interest. This process is called discounting.

The end result is that the bank ends up holding the promise to pay from the buyer. Even though the buyer is the one who must pay, the bank has endorsed this acceptance. Hence, in a way, the bank is ultimately liable to pay.

Since the creditworthiness of the bank is very high, there are a large number of buyers who are willing to buy this acceptance in the secondary market. Also, in some cases, the seller does not discount the receivables with the bank. Instead, it simply sells this acceptance in an open market in order to receive funds.

Hence, banks and exporters often sell these acceptances in the secondary market and recoup their funds. This is how banker’s acceptance securities are created.

Advantages of Bankers Acceptance

Banker’s acceptance has several advantages. Some of these advantages have been mentioned below in this article.

1. More Funds can be Raised: Banker’s acceptance helps facilitate trade and commerce where it would have been difficult under normal circumstances. Hence, it helps companies conduct more business. At the same time, it also ensures that the bank’s capital is not locked in these deals. The secondary market provides liquidity to the bank which can continue using its capital to make more loans.

2. Lower Cost of Funding: Banker’s acceptance has a lower cost of funding for companies as compared to many other alternatives. In most cases, the cost of issuing a banker’s acceptance is the same as taking a short-term loan. In a few cases, it may even be lower than taking a short-term loan. The ends result is that the overall cost of funding is low making this instrument more desirable.

3. Secured: The exporter is comfortable providing their goods on credit since they have the acceptance of a large financial institution. As a result, the entire transaction is considered to be secured since it is being monitored and executed by a financial behemoth.

4. Liquid: The inclusion of a large third-party financial company means that a large number of parties are willing to hold the banker’s acceptance. This increased liquidity which results from the bank’s endorsement is what results in the creation of a money market security.

Disadvantages of Bankers Acceptance

Banker’s acceptance also has certain disadvantages. Some of these disadvantages have been mentioned below:

1. Credit Risk of Banks: The bankers’ acceptance basically passes over the credit risk from the buyer to the bank. Hence, if any bank starts underwriting a large number of acceptances, then they are basically creating a large amount of credit risk for themselves. Also, if the bank is facing financial duress due to some other unrelated reasons, there could still be a huge impact on their banker’s acceptance business.

2. May Be Expensive for Buyer: Also, banks do not generally easily hand out bankers’ acceptances. They often conduct a thorough check of the borrower’s business. This could be a time-consuming process. Also, the bank may ask the borrower to deposit collateral before they can issue the banker’s acceptance. The inclusion of collateral is what ends up making this an expensive proposition for the buyers.

The conclusion is that a banker’s acceptance is a unique form of money market instrument which is generally created as a result of foreign trade.

In a lot of cases, it makes perfect financial sense to use a banker’s acceptance to finance transactions. Also, it provides a liquid and safe instrument which can be used by money market investors to park their funds in the short term.