An ongoing study of international finance practices, initiated in 1980 by the Thunderbird International Trade & Finance Center, reveals that trade finance - specifically, the use of "confirmed letters of credit" or "letter of credit" (LC) - has a much lower incidence of losses, defaults, reschedulings, or restructurings than other normal term international loans. This lower incidence of problems is true whether loans are made to the government or to the private sector.
The study's criteria for defining a loss assume that the bank must have appropriate operational capabilities or professionals properly trained to perform the transaction. The bank also must have the ability to analyze country risk as well as foreign bank risk. If the bank is unable to meet these performance assumptions, poor credit decisions by unqualified lending officers lead to losses on letters of credit.
The hypothesis tested in Thunderbird's study is the following: As a credit instrument, the confirmed LC is a safer instrument with a lower loss record and fewer restructurings than other international commercial loans, particularly term loans. The implication is that commercial banks whose international lending consists of trade finance - in particular letters of credit - have a safer or healthier international portfolio than banks involved in other types of international lending activities. Since a large percentage of bank lending to Asia consists of LCs, the impact of the Asia financial crisis on banks' performance and lending there is expected to be limited.
Traditional View of Trade Finance
The foregoing hypothesis - that trade finance is safer - is based on the argument that a country will not default on trade finance because this would result in that country not being able to import required products to support domestic economic activity. Cut off from imports that are required to generate exports in support of hard currency earnings, the country would rather quickly experience a slowdown in economic growth, debt servicing problems, and perhaps political disruptive effects. So there is an association between preventing defaults or loan losses on trade credits with that immediate need to support critical consumption or productive domestic economic activity.
In contrast, normal international loans are associated with longer-term economic development. A restructuring or renegotiation of a term international loan is not likely to cause the same intensity of immediate hardship to an economy; instead, the hardship is likely to be felt over a …