What is Letter of Credit? Explained

What is Letter of Credit?

A letter of credit is simply a guarantee document from a bank or financial institution, ensuring that a seller will receive a payment due from a buyer on time and for the correct amount. But the seller will not be paid until the bank receives a confirmation that the goods have been shipped for buyer.

So a letter of credit is

·         basically a guarantee from a bank

·         bank's written promise

·         written commitment to pay

Why use a letter of credit?

Letters of credit are most common in international transactions. Importing and exporting from one country to another involves risks. Exporters face risk of buyers failing to pay for goods and importers risk paying but never receiving anything, though both parties have an agreement or an underlying contract. There are other factors involve in international dealing such as distance, different laws, difficulty in knowing each other personally. In this complex situation the use of Letters of credit is very important in international trade. Both parties need guarantee for receiving goods and payment. So Letters of Credit work as a tool to reduce risk for buyers and sellers.

Letter of Credit/Documentary Credit

Advantages for buyers:

§ Seller will not be paid until the bank receives a confirmation that the goods have been shipped for buyer.

§ The bank will pay the seller for the goods only when all the terms & conditions will fulfil according to the Letter of Credit. This assurance provides security to buyer for future business plan.

§ Letter of Credit reduces risk of poor performance by the seller.

§ The buyer can control the time period for shipping of the goods.

§ By a letter of credit, the buyer demonstrates his solvency.

§ In the case of issuing a letter of credit providing for delayed payment, the seller grants a credit to the buyer.

§ Providing a letter of credit allows the buyer to avoid or reduce pre-payment.

§ Shipment under Letter of credit is treated with most care to meet delivery schedule and other required parameters by the exporter.

§ The letter of Credit creates considerable pressure on the seller to supply the goods within the scheduled time and with the required quality.

Advantages for sellers:

·         By the Letter of Credit the seller is reassured for receiving payment in full and on time.

·         The risk of non-payment is transferred from the seller to the bank.

·         The seller can use Letter of Credit as a guaranty for his own suppliers.

·         Based on a high quality export letter of credit, seller can obtain a loan from bank.          

When to use a letter of credit

Of course Letter of Credit is very useful, but it’s often best to avoid using one for a transaction. They can sometimes result in expensive delays, bureaucracy and unexpected costs.

Letter of Credit from Importer:

You should probably only consider opening a letter of credit as an importer:

·         If your supplier insists.

·         If national exchange controls require.

Letter of Credit for Exporter:

Make sure you have a clear policy in your business about when to consider using a Letter of Credit. Think carefully about whether or not you need to ask an overseas customer for a letter of credit.

Important things to consider:

§ Legal matters - does the country you’re exporting to require one?

§ Costs - does the value of the order justify the bank charges and extra costs involved, and who pays these costs?

§ The customer’s creditworthiness - do they have a track record with you?

§ Risks associated with the country you’re exporting to - is it politically stable with a good reputation as an international trading partner?

§ Normal trading practices - is it standard practice for exporters to use letters of credit when trading with that country, and/or in that particular commodity?

§ Available advice and guidance - banks may recommend using of a letter of credit in certain trading situations regardless of other factors, while credit insurers sometimes insist on it.

If you do decide that a letter of credit is the best option you’ll need to consider which type of letter to use. A confirmed and irrevocable’ letter of credit is the most secure type.

Other important things to consider:

Bank make charges for providing Letter of Credit, so be aware of the additional costs involve in using a Letter of Credit, it’s sensible to weigh up costs against the security benefits.

If you’re an exporter you should be aware that you’ll only receive payment if you keep to the strict terms of the letter of credit. Using a letter of credit can sometimes cause delays and other administrative problems.

Pitfalls of Letters of Credit

Letters of credit make it possible to do business worldwide. They are important and helpful tools, but you should be careful when using letters of credit.

As an exporter, make sure you:

§ Carefully review all requirements for the letter of credit before moving forward with a deal.

§ Understand all the documents required.

§ Are truly able to get all the documents required for the letter of credit.

§ Understand the time limits associated with the letter of credit, and whether they are reasonable.

§ Know how quickly your service providers (shippers, etc) will produce documents for you.

§ Can get the documents to the bank on time.

§ Make all documents required by the letter of credit match the letter of credit application exactly (even typographical errors or common substitutions can cause problems).

How to get a Letter of Credit

You need to contact your bank to get a letter of credit. You will most likely need to work with an international trade department or commercial division. Not every financial institution works with letter of credit, but small banks and credit unions often refer you to somebody who is able to accommodate your needs.

By M A Siddque