Letter of credit is a payment instrument used majorly in international trade in which a bank provides monetary guarantee to enterprises which deal in import and export of goods. Letter of credit can be used for both import and export purposes. Enterprises doing businesses overseas have to deal with unknown suppliers and they require assurance of payment before performing any transaction. Therefore, letter of credit is important to provide payment assurance to the suppliers or exporters.
Parties involved in the Letter of Credit (L/C)
Applicant is the buyer (importer) of the goods and services on whose behalf the letter of credit is issued.
Issuing bank is the bank that issues the letter of credit and assures that the bank will pay on behalf of the applicant. Usually the issuing bank is an Indian bank where the applicant holds an account.
Beneficiary is the seller (exporter) of goods and services in whose favor the letter of credit is issued. The beneficiary exports the goods on behalf of the issued letter and receives the payment later. Beneficiary is generally an overseas business partner of the applicant.
Advising Bank is basically an international bank that checks the authenticity of the letter of credit and informs the exporter or beneficiary about it.
Nominated Bank is an international bank in the exporter’s country that is authorized by Indian bank to receive or negotiate the documents and pays the amount to the exporter under the line of credit.
To get a letter of credit, certain documents are to be provided by the consumer to the issuing bank (Indian Bank). This letter guarantees the seller that the payment shall be made in case the buyer is unable to pay. Bank is at risk, if this happens but there is also an advisory bank (Indian bank) at rescue that pays on behalf of issuing bank.
Letter of credit is commonly divided into two categories, such as commercial and standby letter of credit. Wherein commercial letter of credit is considered as primary instrument and standby letter of credit is secondary.
Let’s now understand the procedure of letter of credit that how it works.
How does it work?
Step 1: The applicant or the buyer approaches the desired bank for issuance of letter of credit. This bank is known as opening or issuing bank.
Step 2: There will be advising bank (mostly international bank) for beneficiary or seller that will receive the Letter of Credit been issued by the issuing bank of the buyer. Further the advising bank will check the authenticity of the letter of credit by checking the name, product details, etc.
Step 3: Advising bank will share the letter of credit with the seller by keeping him/her rest assured that the money shall be received, as banks are now involved in this process.
Step 4: Post seller assurance, the goods will be shipped as per the details mentioned by the buyer or applicant. The seller will now receive the bill of lading as the seller has already exported the goods.
Step 5: The buyer shall now present the Bill of Lading to the Nominated or the Negotiating bank (International bank) where the bank will check all the shipping documents, whether all goods were shipped as per the instructions. Finally, the nominating bank will do the payment to the seller or exporter.
Step 6: Further the nominating bank will share the shipping documents with the issuing bank and will demand payment.
Step 7: Issuing bank will further share the documents with the buyer, seeking the approval whether all documents the correct, as per the buyer’s information and all the products are shipped or not.
Step 8: The buyer now does the payment to the issuing bank and further the issuing bank sends the payment to the nominated or negotiating bank.
Types of Letter of Credit
Credit on sight
In this type of credit, entrepreneur can present a bill of exchange to lender with a sight letter and can take the funds instantly on the basis of letter of sight. Sight letter of credit is considered to be the most instant letter of credit that can be availed immediately.
Bill of exchange which is paid after agreed time period between the lender and the borrower is known to be time credit. Certain time period is involved in this type of credit. Letter of credit defining time credit allows borrower with some days to repay the amount, only after receiving the goods.
Revocable credit is a type of letter of credit in which the terms and conditions of this type of LC can be amended or cancelled by the issuing bank. It is not important for the issuing bank to tell beneficiaries regarding any change in the letter of credit.
Irrevocable Credit is a type of LC in which the terms and conditions cannot be amended or cancelled by the issuing bank. The bank has to obey the directions or commitments mentioned in the letter of credit.
Transferable credit, as the name suggests is a type of LC in which the beneficiary can transfer his/her rights to third parties. The terms and conditions may differ as per the trade and industry.
Features of Letter of Credit
- Letter of credit is issued against collateral that may include buyer’s fixed deposit and bank deposit, etc. as security
- Certain fees is charged by the bank depending on the type of letter of credit
- Guidelines are issued by International Chambers of Commerce (ICC) for any form of Letter of Credit
- Correctness of Letter of Credit: As only documents are exchanged and no good and services are involved in this process. Therefore, mentioned details in letter should be correct that include name of seller, date, amount, product name and quantity, etc.
- Banks will deny the payment, if they find any slightest mistake in the buyer’s name, product name, shipping date, etc.
- As all parties deals in documents only and not goods and services, so the payment will not depend on the defects in goods and services, if any
In this whole process, there may be a scenario where the credit rating of the issuing bank may get questioned. Wherein the advising bank thinks that the issuing bank possesses low credit rating. Then the issuing bank will approach a big or established bank, here may be known as confirming bank to ask for a guarantee. The confirming bank will provide a guarantee stating that, if the issuing bank defaults in paying the amount to the beneficiary, then it will take the responsibility in doing the payment on their behalf. This final step marks the end of the line of credit procedure.