Industry Publications

(July/August) Summer 2010

Adam Goldstein, SVP, Head of Marketing and Sales,
Federal Home Loan Bank of New York

Letters of Credit Gain Momentum as an Alternate Means to Secure Public Deposits

This article appeared in the:
New York State GFOA - New York GFOA Newsletter
Association of Towns of the State of New York - Talk of the Towns & Topics Publication
New York State Association of Counties - NYSAC News

When depositing a significant amount of public funds with a financial institution, municipalities understandably require these deposits to be properly secured. Municipalities have customarily requested financial institutions to collateralize their deposits with securities. While this method of collateralization is sufficient, the troubled economy and stock market retraction has dampened security growth because the yields offered in the fixed-income sector have become unattractive.

This trend, coupled with acceptance and awareness from municipalities over the past several years, has increased financial institutions’ usage of Letters of Credit (L/Cs), offered by many institutions, including the Federal Home Loan Bank of New York (“FHLBNY”), as an alternate way to secure public deposits. Financial institutions use L/Cs to facilitate a variety of transactions with third parties since they are operationally efficient for all parties involved. This piece will explain what the L/C product is, why and how it is used, and why you should be comfortable accepting L/Cs as collateral in lieu of securities for your public deposits.

What is an L/C?

Letters of credit are credit instruments that are issued by a financial institution to guarantee payment on behalf of its customer to a beneficiary (normally to a third party but sometimes to the financial institution’s customer) for a stated period of time and subject to certain conditions.

Why do financial institutions prefer using L/Cs?

State, county, and local municipal deposits have steadily increased over the past eight years, creating an increased demand for L/Cs as collateral. When public deposits are collateralized with securities, additional operational expenses are incurred by a financial institution. For example, securities need to be monitored and tracked to ensure that values do not fluctuate below the original amount deposited.

Many financial institutions find that L/Cs offer a more attractive way to collateralize public deposits because this method of collateralization is more efficient for all parties involved and L/Cs alleviate the operational expense of tracking and monitoring pledged securities. The securities that are freed up can then be used to back home mortgage and community development loans to further enhance local community and economic growth.

Why should you be comfortable accepting L/Cs?

L/Cs provide municipalities with a prompt payout for the full dollar amount of their deposit in the event of a draw. If securities are pledged as collateral and the municipality’s financial institution should default (albeit unlikely), it will trigger a liquidation process. This process may hinder the promptness of the payout to the municipality, as the securities need to be sold in the open market.

An L/C eliminates this potential time delay. In the unlikely event that the municipality’s financial institution defaults on its commitment, the municipality submits the draw request to the financial institution issuing the L/C directly for prompt payment.

Municipalities especially find L/Cs appealing because, unlike securities, the value of an L/C remains constant and does not change with market fluctuations. Accepting L/Cs as collateral poses no additional cost to the municipal depositor, and often the operational expenses saved by using L/Cs is passed down from the originating financial institution to the depositor, which can result in higher yields on the municipal funds

Over the past several years, the FHLBNY has seen its member financial institutions’ usage of L/Cs increase and has noticed a growing trend that once a municipality has become familiar with the L/C product, it routinely accepts them as collateral going forward. To address the increased demand for this product, the FHLBNY recently created an additional L/C product that offers the flexibility to account for balance fluctuations with transactional accounts. Visit www.fhlbny.com/lc to learn all about this product and to view a sample L/C, the laws governing L/Cs, the issuance process, related articles, and a listing of FHLBNY members.


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