Meaning and Importance of Letter of Credit
Letter of Credit
A letter of credit is a letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make a payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase.
Due to the nature of international dealings, including factors such as distance, differing laws in each country, and difficulty in knowing each party personally, the use of letters of credit has become a very important aspect of international trade.
How a Letter of Credit Works?
Because a letter of credit is typically a negotiable instrument, the issuing bank pays the beneficiary or any bank nominated by the beneficiary. If a letter of credit is transferable, the beneficiary may assign another entity, such as a corporate parent or a third party, the right to draw.
Banks also collect a fee for service, typically a percentage of the size of the letter of credit. The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits oversees letters of credit used in international transactions. There are several types of letters of credit available.
IMPORTANCE OF LETTER OF CREDIT
A letter of credit enjoys various advantages in executing an international trade transaction. Some of the major ones are below:
- Safely Expand Business Internationally
A letter of credit gives the trade partners an ability to transact with unknown partners or in newly established trade relationships. It helps in expanding their business quickly into new geographies.
- Highly Customizable
A letter of credit is highly customizable. Both the trading partners can put in terms and conditions as per their requirements and arrive at a mutual list of clauses. It can also be customized from one transaction to another with the same trading partners.
- Seller Receives Money on Fulfilling Terms
A letter of credit makes the issuing bank independent of the trading partners’ obligations and any disputes arising out of those obligations. The bank has to just check whether the documents submitted by the beneficiary satisfy the terms and conditions specified in the letter of credit, and pay the full amount.
- WORKS as a Credit Certificate for Buyer
A letter of credit transfers the credit-worthiness from the importer or buyer to the issuing bank. The importer can do multiple transactions at the same time when he is backed by an established and larger institution such as a bank.
- Seller is Free of Credit Risk
A letter of credit is safer for the seller or exporter in case the buyer or importer goes bankrupt. Since the creditworthiness of the importer is transferred to the issuing bank, it is the bank’s obligation to pay the amount as agreed in the letter of credit. Thus, a letter of credit insulates the exporter from the importer’s business risk.
- Quick to Execute for Creditworthy Parties
A letter of credit is quick to execute. As per the initial terms and conditions, the seller or exporter has to present the proof of material type and quantity along with the shipping documents supporting his claim that the goods have been shipped. The advising bank will verify the documents and give the full payment.
- Payment Assured in Disputable Transactions
In the case of a dispute between the trading partners, the exporter can withdraw the fund as agreed upon in the letter of credit and resolve the disputes later in the court. The beneficiary’s right to the full amount is described in the phrase ‘pay now, litigate later’ by the courts.
The importer cannot hold or deny the payment to the exporter by raising objections on the quality of goods because the bank just needs to see the documents satisfying the shipping terms and conditions as put in the letter of credit.
Types of Letters of Credit
- Commercial Letter of Credit
This is a direct payment method in which the issuing bank makes the payments to the beneficiary. In contrast, a standby letter of credit is a secondary payment method in which the bank pays the beneficiary only when the holder cannot.
- Revolving Letter of Credit
This kind of letter allows a customer to make any number of draws within a certain limit during a specific time period.
- Traveler’s Letter of Credit
For those going abroad, this letter will guarantee that issuing banks will honor drafts made at certain foreign banks.
- Confirmed Letter of Credit
A confirmed letter of credit involves a bank other than the issuing bank guaranteeing the letter of credit. The second bank is the confirming bank, typically the seller’s bank. The confirming bank ensures payment under the letter of credit if the holder and the issuing bank default. The issuing bank in international transactions typically requests this arrangement.
An Example of a Letter of Credit
Citibank offers letters of credit for buyers in Latin America, Africa, Eastern Europe, Asia, and the Middle East who may have difficulty obtaining international credit on their own. Citibank’s letters of credit help exporters minimize the importer’s country risk and the issuing bank’s commercial credit risk.
Letters of credit are typically provided within two business days, guaranteeing payment by the confirming Citibank branch. This benefit is especially valuable when a client is located in a potentially unstable economic environment.