Banker's Acceptance (BA): Definition & Overview
Banks and other types of financial institutions have several guidelines and processes in place for the lending market. They’re intended for many reasons which include protection from market risk in financial transactions, for both you and the banks.
Banker’s acceptances are often used by a wide range of companies when making large transactions. But what else do you need to know? Keep reading to learn all about banker’s acceptance, how it works, and the advantages and disadvantages.
Table of Contents
- A banker’s acceptance is a type of payment that gets guaranteed by a bank. This is instead of an individual account holder making the guarantee.
- The payment that the bank guarantees will get paid at a future date.
- Banker’s acceptances can work similar to investments, meaning that they can get traded at a discounted price.
What Is a Banker’s Acceptance?
A banker’s acceptance (BA) is a type of payment instrument that basically shows a bank has the intention of making a future payment. In a lot of ways, it works in a similar way to a post-dated check. But instead of the account holder, the bank guarantees that the payment will happen.
Banker’s acceptances can also commonly get referred to as bills of exchange. They allow for larger transactions and payments to get made safely. As well, similar to Treasury bills, a banker’s acceptance can get traded at a discount in different money markets.
These money market instruments can be most common in international trade.
How Does a Banker’s Acceptance Work?
When a business issues a banker’s acceptance, it works as a way for the company to pay for a specific purchase. This allows them to not have to borrow any money or receive financing to do so. On the flip side, the company that receives the banker’s acceptance understands that it’s a guaranteed form of payment.
When this happens the bank is required to pay the acceptance holder a specific amount of money by a certain date that gets set. They’re often issued 90 days before the date of maturity. However, they can get issued anywhere from one to 180 days.
Yet, when a banker’s acceptance gets issued, it gets issued at a discount to its original face value. This ultimately means that they can get traded in a similar way to bonds in a secondary market. As well, the only downfall of cashing them early is the potential for lost interest that could have been earned.
Important Distinctions of Banker’s Acceptance
One of the most important distinctions of a banker’s acceptance is that it has a real secondary market. Post-dated checks don’t have this type of flexibility. This is why a banker’s acceptance can be considered an investment and checks cannot.
If the holder of a banker’s acceptance chooses to sell it at a discounted price on a secondary market, it’s a safe short-term investment for investors.
It was mentioned above, but bankers’ acceptances are common in international trade because of the advantages they offer. An exporter can gain extra peace of mind when they’re waiting for payment since it’s coming from a reputable bank.
As soon as the bank is able to verify the time draft, its main obligation is to ensure the payment gets made. On the opposite side, an importer can also benefit from a banker’s acceptance. This can be common if they’re having difficulty getting forms of financing. Or, if it’s the least expensive option for them to choose.
How Do You Get a Banker’s Acceptance?
Typically, a banker’s acceptance gets created as a financial transaction, a letter of credit, or documentary drafts. All you need to do is contact your bank and be able to prove you have collateral. This lets the bank know that you’re going to be able to repay it in the future.
In a lot of ways, a banker’s acceptance works the same as a fixed-rate short-term loan. A credit check is done and there might even be an underwriting process that happens. As well, you will most likely get charged a certain percentage when you purchase the total acceptance.
Advantages and Disadvantages of Banker’s Acceptances
There can be several advantages and disadvantages to a banker’s acceptance. It’s largely going to depend on what you need it for and the bank you work with. But one of the biggest advantages is that it will be backed by a financial institution and protected against default.
This is going to provide whoever is selling it some extra assurance that everything will go smoothly.
The main risk that can come with bankers’ acceptances is that the bank has to deliver on their promised payment. This is why they often hedge against this by asking for collateral in return.
Let’s take a look at some of the other advantages and disadvantages.
- There are clear assurances and peace of mind for the seller to protect against the possibility of default
- You can have the ability to purchase and sell a wide range of goods more efficiently and timely
- There is a relatively low cost for banker’s assurances compared to the benefit that will get provided
- There isn’t a need to pay for any goods in advance
- To protect themselves, banks might ask you to post collateral before a banker’s acceptance can get issued
- If the purchaser ends up defaulting, the financial institution will be forced to make the payment on their behalf
A banker’s acceptance works in a similar way to a post-dated check. However, the main difference between the two is that a banker’s acceptance can get traded in a secondary market and a check can’t.
The other main difference is that instead of the account holder guaranteeing the transaction, the financial institution will do this. They allow for larger transactions to get made safely and bankers’ acceptances are common in international trade. It’s an effective money market instrument to use, but you might need a strong credit rating to purchase one.
FAQs About Banker’s Acceptance
Simply put, the banker’s acceptance rate is the specific market rate that it can get traded at. Basically, it’s the total return that a potential investor could receive from their investment. And this would be the case if they purchased today and then held the acceptance until the payment date.
It all starts with a deposit that would line up with the amount of the future payment with fees included. A time draft would get drawn and issued for the payment to get made at a future date. The bank then guarantees the payment to the holder of the acceptance.
This relates to the fee that is payable on the total amount of each banker’s acceptance. A fee can also be part of the issuance of a discount note.
A banker’s acceptance gets used as a primary means of ensuring a future payment gets made. A letter of credit will get issued to an importer who will then send it to the exporter of the product getting purchased.
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