What is a Letter of Credit?
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.
Letter of credit is credit limit or loan amount in form of credit used in international trade to provide payment guarantee from a bank to an exporter.
How Does a Letter of Credit Work?
Letter of Credit is issued by the bank to the buyer in order to secure the timely payment by the buyer to the seller. It acts like a guarantee on behalf of the buyer that he/she pays the full amount to the seller, as per defined timeline or on time. If in case the buyer is unable to repay the amount to the seller on time, then the bank will pay on buyer’s behalf to the seller.
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
Types of Letter of Credit in India
1. 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.
2. Time Credit
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.
3. Standby Letter of Credit (SBLC)
Standby Letter of Credit (SBLC) is a credit mechanism in which importer can get foreign currency funds internationally by providing the issuance of SBLC from domestic bank that guarannatees payment to the international bank, if the borrower fails to repay the amount before on the due date.
4. Revocable Credit
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.
5. Irrevocable 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.
6. Transferable 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.
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Process of Letter of Credit
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.
What are the documents required for opening a letter of credit?
Below stated are the documents required to obtain a Letter of Credit:
- Bill of Exchange
- Commercial Invoice
- Certificate of Origin
- Health and Insurance certificates – Original
- Buyer’s Financial Documents
- Packing, Shipping and Transport Documents
- Landing airway bills, cargo receipts, etc.
- Related Commercial documents – Certificate of Inception
- Official Documents required by buyer’s/seller’s country
Bank Guarantee vs. Letter of Credit: What’s the Difference?
Bank Guarantee is much more similar to Letter of Credit but there is one major difference between them is that the process of letter of credit will proceed even if the buyer defaults in payment. However, in case of Bank Guarantee the bank reduces the loss incurred, if the transaction is not performing as per plan.
Difference Between a Loan and a Letter of Credit
Loan is a lump sum amount borrowed to be repaid in a defined period of time in the form of EMIs. Letter of Credit is a credit or loan limit sanctioned by a bank to the borrower in which the borrower has an option of withdrawing small portions from the total sanctioned limit. With loan there is no guarantor whereas in case of letter of credit, the bank becomes the guarantor for the buyer.
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.
It is commonly divided into two categories, such as commercial and standby letter of credit. Wherein commercial is considered as primary instrument and standby letter of credit is secondary.
FAQs on Letter of Credit
Q. What are the benefits of a Letter of Credit?
Ans. Below mentioned are the benefits of Letter of Credit:
- Acts a credit certificate for buyer in form of ‘Bill of Exchange’
- Timely payments to seller
- Safest mode to expand export import business
- Letter of Credit can be customized as per business needs
- No risk for Seller, receives money on fulfilling terms
- Bank being a guarantor, payment is secured
Q2. What are the risks of a letter of credit?
Ans. There are several risks involved in the process of Letter of Credit that are as follows:
- Non-delivery of Goods
- Low Quality Goods
- Exchange rate of goods
- Return option not available
- Bank’s bankruptcy risk
- Forex Exchange rate concerns
- Fraud altering Letter of Credit, etc.
Q3. How much do banks charge for a Letter of Credit?
Ans. The bank’s interest rate for a letter of credit shall vary from case to case and depends on business volume, nature of the business, buyer’s relationship with the bank and financial stability, country of trade, type of goods, etc.
Q4. How long does it take to get a Letter of Credit?
Ans. The time duration to get a letter of credit depends on the guarantor or the bank offering loan. Generally, the whole loan approval process takes around 10-15 working days or even more in getting a letter of credit approved by the bank. Rest, it also depends on the buyer’s relationship with the bank and nature of business along with business volume and types of goods.