letter of credit

Letter Of CreditLetter Of Credit

DefinitionDefinition A document issued by a financial institution A document issued by a financial institution

on behalf of a buyer stating the amount of on behalf of a buyer stating the amount of credit the buyer has available, and that the credit the buyer has available, and that the institution will honor drafts up to that amount institution will honor drafts up to that amount written by the buyer. It gives the buyer the written by the buyer. It gives the buyer the prestige and financial backing of the issuing prestige and financial backing of the issuing institution and satisfies the requirements of institution and satisfies the requirements of the seller in completing the transaction. The the seller in completing the transaction. The accepting institution has a prior agreement accepting institution has a prior agreement as to how the buyer will pay for the drafts as as to how the buyer will pay for the drafts as they are presented. they are presented.

A commitment, usually by a bank on behalf A commitment, usually by a bank on behalf of a client, to pay a beneficiary a stated of a client, to pay a beneficiary a stated amount of money under specified conditions. amount of money under specified conditions.

Parties involved in LC Parties involved in LC transactiontransaction The The ApplicantApplicant is the party that arranges is the party that arranges

for the letter of credit to be issued.for the letter of credit to be issued. The The BeneficiaryBeneficiary is the party named in is the party named in

the letter of credit in whose favor the the letter of credit in whose favor the letter of credit is issued.letter of credit is issued.

The The Issuing or Opening BankIssuing or Opening Bank is the is the applicant’s bank that issues or opens the applicant’s bank that issues or opens the letter of credit in favor of the beneficiary letter of credit in favor of the beneficiary and substitutes its creditworthiness for and substitutes its creditworthiness for that of the applicant.that of the applicant.

Parties involved in LC transaction Parties involved in LC transaction (Contd..)(Contd..)

An An Advising BankAdvising Bank may be named in the letter may be named in the letter of credit to advise the beneficiary that the letter of credit to advise the beneficiary that the letter of credit was issued. The role of the Advising of credit was issued. The role of the Advising Bank is limited to establish apparent Bank is limited to establish apparent authenticity of the credit, which it advises.authenticity of the credit, which it advises.

The The Paying BankPaying Bank is the bank nominated in the is the bank nominated in the letter of credit that makes payment to the letter of credit that makes payment to the beneficiary, after determining that documents beneficiary, after determining that documents conform, and upon receipt of funds from the conform, and upon receipt of funds from the issuing bank or another intermediary bank issuing bank or another intermediary bank nominated by the issuing bank.nominated by the issuing bank.

The The Confirming BankConfirming Bank is the bank, which, is the bank, which, under instruction from the issuing bank, under instruction from the issuing bank, substitutes its creditworthiness for that of the substitutes its creditworthiness for that of the issuing bank. It ultimately assumes the issuing issuing bank. It ultimately assumes the issuing bank’s commitment to pay.bank’s commitment to pay.

Letter of Credit ProcessLetter of Credit Process

Commercial Letter of Credit Commercial Letter of Credit Flow Flow

1.1. Applicant approaches Issuing/ Opening Bank with Applicant approaches Issuing/ Opening Bank with LC application form duly filled and requests Issuing LC application form duly filled and requests Issuing Bank to issue a Letter of Credit in favour of Bank to issue a Letter of Credit in favour of Beneficiary.Beneficiary.

2.2. Issuing Bank issues a Letter of Credit as per the Issuing Bank issues a Letter of Credit as per the application submitted by an Applicant and sends it application submitted by an Applicant and sends it to the Advising Bank, which is located in to the Advising Bank, which is located in Beneficiary’s country, to formally advise the LC to Beneficiary’s country, to formally advise the LC to the beneficiary.the beneficiary.

3.3. Advising Bank advises the LC to the Beneficiary.Advising Bank advises the LC to the Beneficiary.4.4. Once Beneficiary receives the LC and if it suits his/ Once Beneficiary receives the LC and if it suits his/

her requirements, he/ she prepares the goods and her requirements, he/ she prepares the goods and hands over them to the carrier for dispatching to hands over them to the carrier for dispatching to the Applicant.the Applicant.

5.5. He/ She then hands over the documents along with He/ She then hands over the documents along with the Transport Document as per LC to the the Transport Document as per LC to the Negotiating Bank to be forwarded to the Issuing Negotiating Bank to be forwarded to the Issuing Bank. Bank.

Commercial Letter of Credit Flow Commercial Letter of Credit Flow (Contd..)(Contd..)

6. Issuing Bank reimburses the Negotiating Bank with 6. Issuing Bank reimburses the Negotiating Bank with the amount of the LC post Negotiating Bank’s the amount of the LC post Negotiating Bank’s confirmation that they have negotiated the confirmation that they have negotiated the documents in strict conformity of the LC terms. documents in strict conformity of the LC terms. Negotiating Bank makes the payment to the Negotiating Bank makes the payment to the Beneficiary.Beneficiary.

7. Simultaneously, the Negotiating Bank forwards the 7. Simultaneously, the Negotiating Bank forwards the documents to the Issuing Bank to be released to documents to the Issuing Bank to be released to the Applicant to claim the goods from the carrier.the Applicant to claim the goods from the carrier.

8. Applicant reimburses the Issuing Bank for the 8. Applicant reimburses the Issuing Bank for the amount, which it had paid to the Negotiating Bank.amount, which it had paid to the Negotiating Bank.

9. Issuing Bank releases all documents along with 9. Issuing Bank releases all documents along with the titled Transport Documents to the Applicant. the titled Transport Documents to the Applicant.

Types of Letters of CreditTypes of Letters of Credit

RevocableRevocable IrrevocableIrrevocable UnconfirmedUnconfirmed ConfirmedConfirmed TransferableTransferable Assignment of ProceedsAssignment of Proceeds RevolvingRevolving StandbyStandby

Settlements Under a Letter of Settlements Under a Letter of Credit Credit All commercial letters of credit All commercial letters of credit

must clearly indicate whether they must clearly indicate whether they are payable by sight payment, by are payable by sight payment, by deferred payment, by acceptance, deferred payment, by acceptance, or by negotiation. These are noted or by negotiation. These are noted as formal demands under the as formal demands under the terms of the commercial letter of terms of the commercial letter of credit.credit.

Settlements Under a Letter of Credit Settlements Under a Letter of Credit (Contd..)(Contd..)

In a In a sight paymentsight payment, the commercial letter , the commercial letter of credit is payable when the beneficiary of credit is payable when the beneficiary presents the complying documents and if presents the complying documents and if the presentation takes place on or before the the presentation takes place on or before the expiration of the commercial letter of credit.expiration of the commercial letter of credit.

In a In a deferred paymentdeferred payment, the commercial , the commercial letter of credit is payable on a specified letter of credit is payable on a specified future date. The beneficiary may present the future date. The beneficiary may present the complying documents at an earlier date, but complying documents at an earlier date, but the commercial letter of credit is payable the commercial letter of credit is payable only on the specified future date. only on the specified future date.

Settlements Under a Letter of Credit Settlements Under a Letter of Credit (Contd..)(Contd..)

An An acceptanceacceptance is a time draft drawn on, and is a time draft drawn on, and accepted by, a banking institution, which accepted by, a banking institution, which promises to honor the draft at a specified promises to honor the draft at a specified future date. The act of acceptance is without future date. The act of acceptance is without recourse as it is a commitment to pay the face recourse as it is a commitment to pay the face amount of the accepted draft.amount of the accepted draft.

Under negotiation, the Under negotiation, the negotiating banknegotiating bank, a , a third party negotiator, expedites payment to third party negotiator, expedites payment to the beneficiary upon the beneficiary’s the beneficiary upon the beneficiary’s presentation of the complying documents to presentation of the complying documents to the negotiating bank. The bank pays the the negotiating bank. The bank pays the beneficiary, normally at a discount of the face beneficiary, normally at a discount of the face amount of the value of the documents, and amount of the value of the documents, and then presents the complying documents, then presents the complying documents, including a sight or time draft, to the issuing including a sight or time draft, to the issuing bank to receive full payment at sight or at a bank to receive full payment at sight or at a specified future date.specified future date.

Advantages of Letter of Advantages of Letter of Credit Credit 1.1. The beneficiary is assured of payment The beneficiary is assured of payment

as long as it complies with the terms as long as it complies with the terms and conditions of the letter of credit.and conditions of the letter of credit.

2.2. The credit risk is transferred from the The credit risk is transferred from the applicant to the issuing bank. applicant to the issuing bank.

3. The beneficiary minimizes collection 3. The beneficiary minimizes collection time as the letter of credit accelerates time as the letter of credit accelerates payment of the receivables.payment of the receivables.

4. The beneficiary’s foreign exchange 4. The beneficiary’s foreign exchange risk is eliminated with a letter of credit risk is eliminated with a letter of credit issued in the currency of the issued in the currency of the beneficiary’s country. beneficiary’s country.

Risks involvedRisks involved1. Since all the parties involved in Letter of 1. Since all the parties involved in Letter of

Credit deal with the documents and not with Credit deal with the documents and not with the goods, the risk of Beneficiary not shipping the goods, the risk of Beneficiary not shipping goods as mentioned in the LC is still persists.goods as mentioned in the LC is still persists.

2. The Letter of Credit as a payment method is 2. The Letter of Credit as a payment method is costlier than other methods of payment such costlier than other methods of payment such as Open Account or Collectionas Open Account or Collection

3. The Beneficiary’s documents must comply 3. The Beneficiary’s documents must comply with the terms and conditions of the Letter of with the terms and conditions of the Letter of Credit for Issuing Bank to make the payment.Credit for Issuing Bank to make the payment.

4. The Beneficiary is exposed to the Commercial 4. The Beneficiary is exposed to the Commercial risk on Issuing Bank, Political risk on the risk on Issuing Bank, Political risk on the Issuing Bank’s country and Foreign Exchange Issuing Bank’s country and Foreign Exchange Risk in case of Usance Letter of Credits.Risk in case of Usance Letter of Credits.

ReferenceReference

(http://www.teachmefinance.com/(http://www.teachmefinance.com/Financial_Terms/letter_of_credit.html) Financial_Terms/letter_of_credit.html)

http://en.wikiversity.org/wiki/http://en.wikiversity.org/wiki/Letters_of_Credit/ResourcesLetters_of_Credit/Resources..

International Trade:Financial Services for International Trade:Financial Services for Importers and Exporters, JP Morgan/Chase Importers and Exporters, JP Morgan/Chase Bank, 2000.Bank, 2000.

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