To define the Letter of CreditLetter of Credit refers to any document which can make a confirmation of payment from the buyer to the seller. It is also known by different names such as documentary credit or banker's Commercial Credit of Letter of the undertaking. Any commercial profit-oriented banks generally issue it in such cases which have a fear of reliability, and the contracting parties cannot be easily or readily determined. The banks generally issue a letter of Credit to ensure timely full payment of the buyer to the seller, and in any case, if the buyer failed to make a payment, then the Bank gets the responsibility to pay whatever amount (partial/whole sum) to the seller. The Bank agrees in issuing Letter of Credit with securities or cash from the buyer. Bank typically collects a fee that is a percentage of size/amount as of the Letter of Credit.
Importance of Letter of CreditLetter of Credit (LC) holds high importance and in this section, we will discuss the major factors of LC.
- Factors include distance, nature of laws is different for different countries and the absence of any physical contact during international trades.
- Financial rules and laws dissimilarities between countries and
- Financial rules and laws dissimilarities between countries and
Well defined process for Letter of CreditAny agreement between nations and where finance and commercial structures are involved, it requires a well-defined process to be followed to disable mishaps and loss of monetary amounts. Described below is the Letter of the credit process.
- After the sales negotiation is done and the concerned parties understand the need for a letter of credit for transactions.
- The applicant (buyer) applies in the Bank to issue a letter of credit under the name of the concerned applicant.
- The Bank studies the deal and understands and then asks for assessing the buyer's credibility is at risk, i.e., the ability of the buyer to pay for the goods.
- The Bank, after accessing the buyers required documents to establish a letter of Credit in the beneficiary of the seller and commence the applicant to pay the seller in return of presentation of certain documents.
- Once the Letter of credits reach the beneficiary (seller) he reads and understands the terms in the Letter and matches with the terms and conditions in the business contract.
- After everything gets good, the seller will either arrange for shipment of goods or ask for the amendment of the Letter of Credit accordingly the trade/sales contract.
- The seller will present all the requested documents such as the Letter of Credit is limited in terms of the validity of Credit, time, the last date of shipment that you will require to submit it to Nominated Bank.
- Bank will check all the submitted files, and then they will think if all of them are in comply with LOC, then only they will honour the person by paying the beneficiary.
What is the need of reimbursing Letter of Credit?Taking a closer look at the reimbursement of Letter of Credit.
- Shipping documents – bill of lading
- Financial documents – bills of exchange
- Commercial documents – invoice, packing details
- Official documents — embassy legalization, license, origin certificate, inspection certificate
- Insurance documents — insurance certificate or policy, but not a cover note.
Classification of Letter of Credit:Some Letters of Credit types include:
- Revocable/Irrevocable - A revocable LC where the issuing Bank can make amends and cancels the LC without any prior notice to the beneficiary. Irrevocable LC is where the issuing bank cannot do any changes in the LC and hence the issuing Bank is bound to its commitments.
- Confirmed/ Unconfirmed – When another bank gets involved other than the issuing Bank and act as a guarantee to the Letter of Credit. It is generally the seller's Bank who confirms payment according to the Letter of credit terms if both the buyer and the issuing bank default.
- Import/Export – Depending upon the perspective, the same LC can be termed as import LC or export LC. If something is going out from the buyer's end or sellers' end, it's the export LC for them and vice-versa.
- Restricted/ Unrestricted – When an LC is limited, the confirmation bank can buy the bill of exchange from the seller. However, in the case of unrestricted LC where the confirmation bank is not specified, the seller is free to collect his dues from any banks with the terms of Letter of Credit.
- Deferred/ Usance - In the absence of immediate credit/agreement payment just after the presentation which gets mutually negotiated after a specific period. This type of LC is termed as Deferred.
- Revolving - This type of Letter will ensure that the consumer to withdraw money up to a specific number of times during a specified period. It also tells you about the letter of credit meaning for Revolving genre.
- Commercial – When the issuing Bank directly pay to the beneficiary
- Stand By – This type of Letter is a secondary matter which when the Bank pays to the recipient only when the buyer fails to pay the amount.
- Sight - It is a type of Credit where the Bank will pay the applicant right away after checking out their documents or files.
- Red Clause -In this case, before sending the products, you can easily ask for the pre-paid section from Bank itself. Here all the rules and regulations have been written in red colour, and this is why the name is Red Clause.
- Back to back – It has a dual-use one for the seller who is unable to provide the required goods, and the other is opened for that seller who sells desired products.
- Transferable – The bills of exchange are negotiable, unlike the Letter of Credit, and the beneficiary can transfer his rights to the third parties.
The possible risk factors regarding Letter of CreditThe possible risks associated with Letter of Credit include:
- Fraud risk - the payment is obtained through the use of falsified or forged documents for worthless or non-existent merchandise
- Regulatory risk - Sometimes, any government decision may pause in all the transactions.
- Legal risk – the regal reasons may bar the transactional process.
- Beneficiary risk - The person who is a beneficiary can easily be exposed to the risk of its failure in terms of failure in payment terms, repayment of the loan amount or even the delay in payment.
- Issuing bank risk – Risk of applicant running an insolvent, before the repay, risk of fraud exposure by the sellers.
Example of Letter of CreditFor buyers in Latin America, Africa, Eastern Europe, Asia and the Middle East who face the problem of obtaining international Credit on their own Citi Bank offers them letters of Credit. The Letter of Credit helps in minimizing the importer's country risk for the exporter and commercial credit risk for Citibank.
Letter of Credit issued within two business days guaranteed payment by the conforming CitiBank branch. These benefits customers can only avail who is living in a potentially unstable environment.
Hence the Letter of credit example helps us to understand the following bulletin points
- A letter of credit is a kind of Letter from a bank guaranteeing the seller to receive payment from the buyer in a definite period and negotiated amount.
- There can be various types of letters of credits, including traveller's Letter of Credit.
- A certain percentage of the size of the Letter of Credit is the fee collected by the Bank to provide this service.
The Utilisation of Letter of CreditWith specified Letter of credit format and understanding the terms and conditions related to Letter of Credit, this could be of a high utilization specifically for the international trade, where the buyer and seller rarely meet. As of now, we have understood some basic detailing regarding Letter of Credit, although this is something more than the tip of ice whatever we have discussed in this comprehensive article.
By following different types of letters of Credit, the buyers and sellers can choose which one is appropriate for them to utilize in the business deal. After agreeing in certain negotiable period and terms with the given process, they can apply of Letter of credits which is an excellent positivity since a well reputed and profitable bank guaranteeing the deal.
This signifies better business within the globe and ease of laws. However, for different countries, there are different ways of applying the basic concept. Letters of Credit not only ensures secure payment and timely payment but at the same time increases the profitability of any public or private sector bank which charges some percentage of the size of the Letter as compensation for issuing the Letter which acts as a guarantee for international trade and business.
It is important since it enables the growth of a country by the flow of foreign money. Therefore, Letter of Credit does not help the buyers to pay the amount or the seller in guaranteeing his payment negotiated with seller's amount but at the same time indirectly helps in bringing foreign cash flow in a nation which ultimately helps in its growth and prosperity.
Letter of Credit should strongly depend on the items that have been business or traded for, and accordingly, selection of its type must be made. There are a lot of provisions of any kind of activity across our planet. But nothing is as easy as it sounds, and Letter of Credit is no alien to this fact.
There are numerous risks that can show up along with issuing of Letter of credits and in that case, each one involved in the Letter of Credit can undergo a reasonable degree of loss or harassment, obviously significant monetary loss but also sometimes intangibles loss account for if the risk factors are not adequately studied. Apart from this fact, a letter of Credit plays a significant role and had made an international payment gateway easy to assess and access.
ConclusionLetter of Credit vs. Bank guarantee is more or less the same but not exactly. People often make mistakes between these two, and it is quite evident because of the smaller difference. So, let us now understand the primary difference.
Both Letter of Credit and bank guarantee can inculcate confidence in the transaction and participating parties, but on the other hand, the Letter of Credit ensures that the transaction goes ahead whereas bank guarantee reduces any loss incurred if the transaction does not go by the plan. Letter of Credit can be termed as the agent who minimizes the risk and bank guarantee as to the agent who fails in contractual obligations.
Letter of Credit is one of the chief facilities and services provided by a bank. It has made international trade and business more comfortable and secure.
With the evolution of humanity and the advancement of technologies letter of Credit had been evolving to serve better in a more flexible way. There is no denying about the usefulness of this Letter with a specific letter of credit format pdf can be readily available on the internet for a better understanding of its documentation requirements.
The strictness is on a higher side in the evaluation of any documents, and hence the buyers and especially the seller must provide all the valid and require documents for claiming his payment from the issuing branch of a bank.