Letters of Credit in Corporate Finance

Tanvi Jindal, Joint Program in Finance and Economics PhD Student

This paper examines how credit risk and buyer–supplier relationships shape firms’ reliance on letters of credit (LCs), a form of bank-backed payment guarantee used in trade finance. I construct new firm-level data on outstanding LCs for U.S. public companies using SEC 10-K and 10-Q filings. LC use increases as firms’ credit quality deteriorates, with a sharp rise around downgrades from investment to speculative grade. Firms in industries whose products use more customized inputs — where switching costs make relational enforcement more credible — rely less on LCs. Firms with greater bargaining power over suppliers also use fewer LCs. I find that LC use increases around downgrades only when firm’s inputs are less customized or when buyers have limited bargaining power. Finally, I examine whether LCs function as a cost of financial distress or as an insurance mechanism that mitigates it using textual analysis from firm’s 10-K and 10-Q filings.