Definition of Letter of Credit:
A letter of credit or LC in simple words refers to a written guarantee or commitment to pay, by a buyer’s (importer’s) bank, which is also known as the issuing bank to the exporter’s or seller’s bank, which is referred to as the negotiating or accepting bank. A letter of credit is also named as a documentary credit or a banker’s commercial credit. LC guarantees payment on the terms that the exporter submits the required documents within a specific time frame. The documents include (clean bill of lading, commercial invoice, certificate of origin, etc.). The person to whom the letter of credit is issued (the exporter) is known as the beneficiary. The importer may make the payment to its bank (the amount that is to be paid to the exporter) or it may negotiate to get credit.
Let’s take a layman example:
Mr. A (Indian nationality; a buyer in this deal) did a business deal with Mr. B (USA nationality; a seller in this deal)of USD $500,000. The deal says that, Mr. A will pay the full committed amount to Mr. B, after 3 days when possession of the goods comes to Mr. A from Mr. B. Now, below are the scenarios which may take place in a hypothesis example:
- A will pay the full committed amount to Mr. B as the per deal’s specific time and currency.
- A has paid 75% of the deal’s amount, and rest 25% – he is unable to pay. So, in this case, Mr. A’s bank will intervene by a surety (Letter Of Credit) that, if Mr. A is unable to pay the specified amount ($500,000) on a specific date (after the 3 days as possession comes to Mr. A) in specific currency (USD Dollars), the bank will pay the deal’s rest amount (25% which Mr. A is unable to pay).
- A is unable to pay 100% of the deal’s amount. This case is same as aforementioned one. The bank of Mr. A will pay the entire amount of the deal to Mr. B’s bank.
The transactions (2) and (3) have use of Letter Of Credit, which have happened in international market.
Nirav Modi and Punjab National Bank Case (2018) or PNB Fraud Case (2018)
In 2018, we have heard lot about a man known as Nirav Modi, who has laundered money through Indian Public Bank, called Punjab National Bank (PNB), of worth around Rs 11,000 crores. Out of the total scam value, Letter of Credits were issued worth of Rs 1,854, by the Punjab National Bank to their own international or oversee branch of Punjab National Bank.
Origin of Letter Of Credit
Everything has origin or history. The Letter Of Credit was a traditional financial payment method in Europe, on which an eye was kept upon by the rules and regulations, rather than a buildup national law. As LC started coming into the circulations and accepted by the banks, The Uniform Customs and Practice for Documentary Credits (UCP) was formed in 1933, to protect and safeguard the interest of the parties involved in the LC’s deal.
There are various types of letter of credit that are used in international trade which are:
Irrevocable and Revocable LC:
An irrevocable LC is the type of Letter Of Credit that can be cancelled or changed only with the consent of the beneficiary. Thus, the bank becomes dependent on the exporter and its bank. A revocable LC is an LC that can be cancelled and changed by the applicant (importer) without the approval of the beneficiary. The bank will have no liabilities to the beneficiary after revocation.
A standby LC is somewhere close to a bank guarantee since the bank makes payment only when the buyer (importer) fails to fulfil payment liabilities of the exporter or seller.
Confirmed and Unconfirmed LC:
In case of a confirmed LC, the exporter’s bank adds a condition that the payment will be made irrespective of the importer making payment to its bank. In case of an unconfirmed LC, the issuing bank will be liable only for payment of this LC (only when the importer makes the payment)
When a particular LC can be transferred by the main beneficiary to another secondary beneficiary, the LC is said to be transferable. However, the second beneficiary cannot further transfer the LC.
Back to Back LC:
In case of a back to back LC, a new LC is issued by the main beneficiary to the second beneficiary taking the original LC as security or guarantee. It is usually used for exporters or suppliers of goods.
Payment at sight LC:
A payment at sight LC also known as sight LC, is characterized by immediate payment (within 7 days) after the required documents have been submitted.
The seller may request and get an agreed amount as advance before the submission of documents and shipment of goods. This portion is printed in red in the document and thus is termed as red clause.
Restricted and Unrestricted LC:
Under a restricted LC only a specific bank is designated to pay for, accept and negotiate the LC. In case of an unrestricted LC there is no such designated bank
Usance LC is a LC wherein credit is paid for by the importer after an indicated period accepted by both buyer and seller. Thus, payment isn’t made immediately after the presentation of documents.
BENEFITS OF Letter of Credit:
- The letter of credit is considered beneficial for both the buyer as well as the supplier in international trade.
- The various advantages of a letter of credit for a buyer i.e. importer:
- The buyer is assured delivery of goods within the specified time period given in the letter of credit. The buyer has to make payment after receiving the documents and receiving the shipment of goods.
- Since the importer’s bank makes the payment on its behalf it gives creditworthiness and makes it easier for the importer to carry out trade. At the same time, it gives extra time to the importer to arrange money for making the payment since they know the payment schedule and hence they can plan accordingly.
- A letter of credit reduces the chance of non-performance by the exporter.
The advantages of a letter of credit for an exporter i.e. seller:
- A letter of credit works as a guarantee to the exporter that assures timely payment irrespective of the importer’s financial status.
- There is a possibility that the exporter might receive payment after submission of documents and before the delivery of goods. In such a case payment takes place before goods are delivered to the importer.
- A LC makes it easier for the exporter to secure pre-order financing and it also mitigates the risk of dealing with an unknown importer in a foreign nation.
- Payment cannot be refused by the importer on account complaint about the goods.
How banks fund Letter Of Credit?
A question hovers in the mind, that, how a bank funds the LC to the buyer?Basically, this is done in the below manner:-
- The banks charge fees from the buyer depending upon the Letter Of Credit’s amount.
- The bank asks for a security, such as cash or collateral, in lieu of issuing LC to the buyer.
Documents required for Letter Of Credit
Various risks are involved in the international market. To being on a safer side, the bank from the seller’s side asks for various documents. Below lists is the document required:
- Financial documents
- Commercial documents
- Shipping documents
- Official documents
- Insurance documents
Risks associated with Letter Of Credit
When you are dealing in an international market, it means, you are in an unknown sea, unknowingly of its risks associated to it; the tides and waves may hurt your boat (business) very badly, and may sink (derail) you.
Risks that can come into your way are as below:-
- Fraud Risks
- Legal Risks
- Issuing Bank
- Credit Risk
- Legal Risk
Any of the party may fail to fulfill the contract, for example, the buyer may not have enough finance available to him, to make a purchase after he has given an order to the seller.
Letter of Credits are used for:-
Protection to buyer:
If a seller is unable to fulfill the contract, then, the buyer can go ahead and claim for the refund of the money. The bank on the seller’s side will pay the money, if the seller is not unable to pay the amount, at the time of non-delivery of the said service. This will concrete the buyer’s confidence in the international market.
Protection to seller:
If the buyer is unable to pay the buyer, then, the seller can exercise the right of Letter Of Credit. The seller can ask for the payment from the bank, which has issued the Letter Of Credit to the buyer.
The conclusion is that the Letter Of Credits are widely accepted into the international financial market. Despite being an negotiable instrument, it has widely gained popularity. Every large bank is now dealing in Letter Of Credits, as it opens the new market: for banks, buyers and sellers.
The buyers and sellers can now openly go for international trade, as they have surety of “Letter Of Credit” in their mind, that their money will not go elsewhere.
Read more about Bill Discounting