Chapter- 18
LETTER OF CREDIT
by
Abdullah Al Masud
Lecturer
Southeast Business School
Southeast University
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Letter of Credit Definition
• A letter of credit is a document that
guarantees the buyer’s payment to the sellers.
It is Issued by a bank and ensures the timely
and full payment to the seller. If the buyer is
unable to make such a payment, the bank
covers the full or the remaining amount on
behalf of the buyer. A letter of credit is issued
against a pledge of securities or cash. Banks
typically collect a fee, i.e., a percentage of the
size/amount of the letter of credit.
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Definition by ICC
A Letter of Credit has been defined by the
International Chamber of Commerce as “
An arrangement, however, named or described
whereby a bank (the issuing bank) acting at the
request and in accordance with the instructions
of a customer (the applicant of the credit), is to
make payment or to the order of a third party
(the beneficiary) or is to pay, accept or
negotiate Bills of Exchange (Drafts) drawn by
the beneficiary or authorize such payments to
be made or such drafts to be paid, accepted or
negotiated by another bank, against stipulated
documents and compliance with stipulated
terms and conditions.” 3
Parties
There are following parties are related to a Letter
of Credit.
(1) The buyer.
(2) The beneficiary.
(3) The issuing bank.
(4) The notifying bank.
(5) The negotiating bank.
(6) The confirming bank.
(7) The paying bank.
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Types of Letters of Credit
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Commercial Letter of Credit
• Such letters of credit are issued to facilitate trade and
commerce particularly the international trade.
• An exporter is reluctant to send goods to the importer
because he wants to minimize the risk for the
payment. Similarly, the importer is also reluctant to
send the payment in advance to the exporter.
• A letter of credit issued by the importer’s bank
guarantees the exporter that the bank will pay or
accept the bill accompanying the documents sent
through the bank.
• The exporter should strictly comply with the terms
and conditions of the letter of credit. In case he fails
to do so, the bank issuing the letter of credit will not
liable to pay or accept the bill drawn by the exporter.
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Letter of Credit (LOC) Steps
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Letter of Credit Steps
• Step 1 The buyer agrees to purchase goods from the seller. This agreement may be a purchase order,
an accepted pro-forma invoice, a formal contract, or an informal exchange of messages. Agreement
is made as to goods being purchased, how and when they are to be shipped and insured, and how
and when payment is to be effected. In this case, the agreement is to use a letter of credit as the
mechanism of payment.
• Step 2 The buyer applies to his bank for a letter of credit, by signing the bank's letter of credit
application/agreement form.
• Step 3 & 4 After approving the application, the issuing bank issues the actual letter of credit
instrument and sends it to the seller (beneficiary) through the advising bank.
• Step 5 Having received the issuing bank's assurance of payment, the seller ships the goods to the
buyer.
• Step 6 The seller prepares the documents called for in the letter of credit and presents them to the
advising bank.
• Step 7 The advising bank sends the documents to the issuing bank.
• Step 8 The issuing bank examines the documents. If it determines that the documents comply with
the letter of credit, the issuing bank pays the seller. The issuing bank obtains payment from the
applicant (buyer) in accordance with the terms of the applicant’s letter of credit agreement and
forwards the documents to the applicant.
The applicant uses the documents to pick up the merchandise from the carrier, completing the letter of
credit cycle.
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Types of Letters of Commercial Credit
• Documentary Letter of Credit
• Clean Letter of Credit
• Fixed Letter of Credit
• Revolving Letter of Credit
• Revocable Letter of Credit
• Irrevocable Letter of Credit
• Confirmed Letter of Credit
• Unconfirmed Letter of Credit
• With Recourse Letter of Credit
• Without Recourse Letter of Credit
• Transferable Letter of Credit
• Non-transferable Letter of Credit
• Back to Back Letter of Credit
• Red Clause Letter of Credit
•
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L/C Sample
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Advantages to the Exporter
• Guarantee of Payment: In case of foreign trade
there is a greater risk as the exporter and importer
do not know each other. Moreover, there are other
risks as well. With the opening of the letter of
credit the exporter is assured of the payment.
• No Risk of Dishonor of Bill: Under the letter of
credit the bill drawn on the importer is accepted
by the negotiating banker. Therefore, there is no
risk of its being dishonored.
• No Risk of Exchange Restrictions: The issuing
banker examines carefully the restrictions
imposed by the importing country before opening
letter of credit. The exporter is saved of the
botheration and risks of foreign exchange
restrictions. 11
Continued………………
• Availability of Advance Under Packing Credit
Facility: An exporter can get advance financial
assistance under packing credit to finance
purchase of raw materials and its conversion into
finished products and other expenses.
• No Risk of Loss Due to Fluctuation in Exchange
Rates: Under letter of credit the exporter is
assured payment in the local currency. Therefore,
he does not run the risk of fluctuation in foreign
rates.
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Advantages to the Importer
• It Facilitates Import: It is very difficult to import
goods as the exporter does not know the importer.
In the absence of letter of credit the exporter may
be reluctant to export goods.
• No Risk in Import: The risks involved in
importing goods directly, is reduced. Under the
letter of credit the importer is assured that the bill
will be paid or accepted only when documents are
received by the negotiating banker.
• Assurance of Compliance of Foreign Exchange
Rules: The issuing banker opens the letter of
credit only when it is satisfied that all the
requirements of foreign exchange rules of the
country of importer have been properly complied
with. 13
Continued………………
• Assurance of Compliance of Foreign
Exchange Rules: The issuing banker opens
the letter of credit only when it is satisfied that
all the requirements of foreign exchange rules
of the country of importer have been properly
complied with.
• Facility of Advance Payment Without any
Risk: Sometimes an exporter insists for
advance payment to buy raw material and meet
other costs. In such a case the importer can
make advance payment by opening ‘Red
Clause Packing Credit’ letter of credit.
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Precautions Taken by the Bank
• Creditworthiness of the Party: Before opening
a Letter of Credit, the banker should examine
the honesty, integrity and creditworthiness of
the importer.
• Validity of the Period: When the bank receives
an application from the importer, it should
examine carefully whether the period of import
license is valid or not.
• Terms of Letter of Credit: The terms and
conditions of Letter of Credit must be
satisfactory. If the negotiating bank fails to
satisfy itself with respect to the terms of Letter
of Credit, it may have no claim against the
bank which issued the Letter of Credit. 15