What Is Banker's Acceptance?
A banker's acceptance (BA) is a time draft drawn on and accepted by a bank, signifying the bank's unconditional promise to pay a specified sum of money on a set maturity date. It is a key instrument within the money market category, primarily used to facilitate international trade. By accepting the draft, the bank assumes primary liability for payment, thereby substituting its own credit risk for that of its client. This makes the banker's acceptance a highly secure and marketable short-term debt instrument.
History and Origin
The origins of banker's acceptances can be traced back to the 12th century, where they emerged as a means to finance uncertain trade by allowing banks to buy bills of exchange at a discount. An active market for sterling banker's acceptances thrived in London during the 18th and 19th centuries. In the United States, the formation of the Federal Reserve System in 1913 was partly intended to foster a domestic banker's acceptance market to compete with London's and boost U.S. trade. The Federal Reserve Act authorized national banks to accept time drafts and allowed the Federal Reserve to purchase eligible banker's acceptances. The Federal Open Market Committee (FOMC) played a role in supporting this market, even authorizing purchases on an outright and temporary basis for the Federal Reserve Bank of New York in 1955 to encourage its redevelopment.5 However, central bank support for the acceptance market was deemed no longer necessary by 1977.
Key Takeaways
- A banker's acceptance is a bank-guaranteed time draft, primarily used in international trade.
- The accepting bank assumes the primary obligation to pay the holder at maturity, enhancing the instrument's safety.
- Banker's acceptances are typically sold at a discount to their face value and can be traded in the secondary market.
- They provide financial assurance to exporters and flexible payment terms for importers.
- Historically, banker's acceptances were actively supported by central banks, including the Federal Reserve, to promote trade.
Formula and Calculation
A banker's acceptance is a discount instrument, meaning it is sold at less than its face value and matures at its face value. The return an investor receives is the difference between the purchase price and the face value. The yield to the investor can be calculated using a simple discount yield formula:
Where:
- Face Value: The amount the holder will receive at the maturity date.
- Purchase Price: The discounted price at which the banker's acceptance is bought.
- Days to Maturity: The number of days remaining until the banker's acceptance matures.
- 360: Standard number of days used in money market conventions for annualizing the yield.
The discount rate inherent in the purchase price determines the yield an investor earns by holding the banker's acceptance until maturity.
Interpreting the Banker's Acceptance
The presence of a banker's acceptance in a transaction signifies a high degree of payment assurance. Because a reputable [financial institution](https://diversification.com/term/financial-in
stitutions) has guaranteed the payment, the instrument carries a lower credit risk compared to a direct promise to pay from a commercial entity. This makes banker's acceptances highly liquid and attractive to investors in the money market. Their market rate reflects the prevailing short-term interest rates and the creditworthiness of the accepting bank.
Hypothetical Example
Consider an importer in the United States, "American Imports Inc.," wanting to purchase specialized machinery from an exporter in Germany, "EuroTech GmbH." EuroTech GmbH wants assurance of payment before shipping the valuable equipment.
- American Imports Inc. arranges with its bank, "Global Bank," to issue a banker's acceptance for $500,000, payable in 90 days.
- Global Bank, after assessing American Imports Inc.'s creditworthiness, "accepts" the time draft, stamping it as a banker's acceptance and committing to pay EuroTech GmbH (or the holder) $500,000 in 90 days.
- EuroTech GmbH receives this banker's acceptance. Knowing it's backed by Global Bank, a well-known financial institution, EuroTech GmbH is confident in shipping the machinery.
- EuroTech GmbH can either hold the banker's acceptance until its 90-day maturity date and receive the full $500,000 from Global Bank, or it can immediately sell the banker's acceptance to another investor in the secondary market at a discount to receive cash sooner. For instance, if the market's discount rate yields $495,000 for immediate sale, EuroTech receives immediate liquidity, sacrificing a small amount for the convenience.
American Imports Inc. is obligated to pay Global Bank $500,000 on or before the maturity date.
Practical Applications
Banker's acceptances are predominantly used in facilitating international trade transactions, particularly where the parties involved may not have established credit relationships. They provide security for exporters and payment flexibility for importers. For example, the Export-Import Bank of the United States (EXIM Bank), which aims to support American jobs by facilitating U.S. exports, is authorized to "purchase, discount, rediscount, sell, and negotiate, with or without its endorsement or guaranty, and to guarantee notes, drafts, checks, bills of exchange, acceptances, including bankers' acceptances."4 This demonstrates their continuing role in official trade finance.
Beyond direct trade financing, banker's acceptances can also be held by financial institutions and other investors as short-term, low-risk investments. They are a component of the money market and can be included in money market funds, valued for their safety and liquidity.
Limitations and Criticisms
While highly secure, the market for banker's acceptances has seen a decline in recent decades, with their volume outstanding significantly lower than in past periods. Data from the Federal Reserve Bank of St. Louis's FRED database illustrates this trend, showing that holdings of banker's acceptances by money market funds have decreased over time.3
One limitation for banks creating banker's acceptances is the regulatory framework. For instance, the Bank Export Services Act (BESA) established limits on the aggregate amount of eligible banker's acceptances that a member bank can create, typically capped at 150% (or 200% with Board permission) of its capital, and 10% of capital for any one person.2 Furthermore, acceptances arising from domestic transactions are generally limited to 50% of a bank's total eligible acceptances.1 These regulations aim to manage bank exposure and ensure proper use of these instruments. The declining use can be attributed to the evolution of global financial systems, the rise of other financing methods, and increased access to direct credit lines for businesses involved in international trade.
Banker's Acceptance vs. Commercial Paper
Both banker's acceptances and commercial paper are short-term, unsecured debt instruments issued at a discount in the money market. However, their fundamental difference lies in the issuer and the backing.
A banker's acceptance is a time draft guaranteed by a commercial bank. Its safety and marketability are primarily derived from the credit risk of the accepting bank, not the original borrower. This makes it a very low-risk instrument, comparable to a bank deposit in terms of safety.
Commercial paper, on the other hand, is an unsecured promissory note issued directly by large corporations to raise short-term funds. Its safety and value depend entirely on the creditworthiness of the issuing corporation. Therefore, commercial paper typically carries a higher credit risk than a banker's acceptance and generally offers a higher yield to compensate investors for this increased risk.
FAQs
What is the primary purpose of a banker's acceptance?
The primary purpose of a banker's acceptance is to facilitate trade, especially international trade, by providing a bank's guarantee of payment. This reduces the credit risk for the seller (exporter) and offers deferred payment options for the buyer (importer).
Are banker's acceptances considered safe investments?
Yes, banker's acceptances are considered very safe investments. The payment is unconditionally guaranteed by the accepting bank, which substitutes its strong credit standing for that of the original borrower. This makes them highly secure instruments in the money market.
Can an investor sell a banker's acceptance before its maturity date?
Yes, banker's acceptances are negotiable instruments and can be sold in the secondary market before their maturity date. They are typically sold at a discount, with the discount amount reflecting the time remaining until maturity and prevailing market interest rates. This feature provides liquidity for investors.
How does a banker's acceptance differ from a letter of credit?
A banker's acceptance is a financial instrument that evidences a bank's promise to pay, arising typically from an underlying trade transaction. Letters of credit are documents issued by a bank that guarantee a buyer's payment to a seller, often specifying conditions that must be met (e.g., presentation of shipping documents) before payment is made. A banker's acceptance can be created under a letter of credit, where the bank's acceptance of a time draft fulfills the payment obligation of the letter of credit at a future date.