The methods of protecting bank notes and deposits have been treated at length in preceding chapters. Bank acceptances are a third form of bank credit requiring protection. This form of liability is incurred when a time bill is presented and accepted by the drawee bank, that is, the bank agrees to pay the bill according to its tenor. The bill is then known as an "acceptance" and is practically a promissory note of the bank.
If a bank owes some person, say, Henry, money, or has agreed for a commission to honor time drafts drawn by Henry, Henry may draw a bill on the bank ordering it to pay to a third party a certain number of days after sight or date, and such a bill may be discounted in the market either before or after acceptance by the drawee bank. The purchaser of the bill may insist that Henry show him a letter from the bank authorizing Henry to draw to a certain amount and under certain conditions; such a letter is called a "letter of credit." To protect himself further the purchaser may require Henry to attach commercial documents or securities as collateral to the bill. Such documents as the bill of lading, warehouse receipt, and the like, constitute the holder the virtual owner of the goods represented. If the drawee fails to accept the bill when presented or to pay the acceptance when due, the holder of the bill and documents can recover by liquidating the collateral. A bill with documents attached is known as a "documentary" bill, and one without documents as a "clean" bill.
The bank incurs successively two liabilities in the above transactions. In the first place it issues to Henry a letter of credit agreeing to accept certain bills to a certain amount when properly drawn. To protect itself against this liability it may require Henry to pledge collateral security, or to pay or deposit cash to the full amount, or to secure the guaranty of some bank or financial institution that he will pay to the bank the amount of the bills drawn under the letter of credit before they mature. The transaction is reflected in the balance sheet by an increase in the liability, Letters of Credit, and an increase in the asset, Customers' Liability under Letters of Credit. The second liability is an absolute liability incurred when the bank accepts bills drawn under the credit. On the liability side the item, Letters of Credit, is decreased and the item, Acceptances, increased, while on the asset side Customers' Liability under Letters of Credit is decreased and Customers' Liability for Acceptances Executed increased. If the bill is documentary, in order to protect itself, the drawee bank may at the time of acceptance remove and keep the documents and, if Henry does not cover the bills drawn according to the terms of the letter of credit, may take possession of the goods and convert them into cash; but if the documents are delivered to the person in behalf of whom the bill was accepted, the bank takes special precautions at the time of acceptance to guard well its interests. The safest way is to deliver documents only against payment, but commerce would be unnecessarily restrained by a rigid adherence to this plan. If the bill is clean rather than documentary it becomes upon acceptance practically an unsecured promissory note and is not necessarily based on a commercial transaction.