A letter of credit is a banking mechanism which allows importers to offer secure terms to exporters. Letters of credit have been used for many years in international trading transactions.
The issuing bank's role is to guarantee to the seller that if compliant documents are presented, the bank will pay the seller the amount due.
"A letter of credit is a payment undertaking given by the issuing bank on behalf of the buyer/applicant to pay a seller/beneficiary a given amount of money on presentation of specified documents representing the supply of goods within specific time limits. These documents must conform to terms and conditions set out in the letter of credit and documents must be presented at a specified place."
Advantages
There are a number of advantages both for the seller/exporter and the buyer/importer.
Seller:
This offers security to the
seller as an assurance of payment from an international bank. (On the condition that the
terms of the letter of credit are complied with.)
The seller can raise finance
when a Letter of Credit has been issued in his favour.
Buyer:
The buyer does not have to pay
cash up front to a foreign country before receiving the documents of title to the goods
purchasd. This is helpful when the buyer is unfamiliar with local suppliers and
legalities.
This protects the buyer's
interests as the bank will only pay your supplier on your behalf if they present x,y,z
documents that you have asked for. Payment will be given if these documents comply with
the terms and conditions set out in the letter of credit.
The buyer can build safeguards
into the Letter of Credit such as inspection of the goods, quality control and set
production and delivery times.
How Does a Letter of Credit Work?
| Step 1 | The buyer and seller agree terms, including means of transport, period of credit offered, latest date of shipment and the relevant Incoterm to be used. |
| Step 2 | The buyer applies to the bank for a letter of credit to be issued. |
| Step 3 | The bank will then evaluate the buyer's credit rating, and may require a cash cover and/or reduction of other lending limits. |
| Step 4 | The issuing bank will issue a letter of credit. This will be sent to the advising bank by airmail, telex or SWIFT |
| Step 5 | The advising bank will establish authenticity of the letter of credit using signature books or test codes, then informs seller (beneficiary). |
| Step 6 | The advising bank may confirm the letter of credit, i.e. add its own payment undertaking |
| Step 7 | The seller should check that the letter of credit matches the commercial agreement, and that the terms and conditions can be satisfied in goodtime. |
| Step 8 | If there is anything that may cause a problem, an amendment should be requested. |
| Step 9 | The seller ships the goods and gathers together all the documents asked for in the letter of credit such as the invoice, transport document ... |
| Step 10 | Before presenting the documents to the bank, the seller should check them for discrepancies against the letter of credit, and correct the documents where necessary. |
| Step 11 | The documents are presented to a bank, often the advising bank. |
| Step12 | The advising bank checks the documents against the letter of credit . If the documents are compliant, the bank pays the seller and forwards the documents to the issuing bank. |
| Step 13 | The issuing bank will also check the documents. If they are in order the issuing bank will reimburse the seller's bank immediately. |
| Step 14 | The issuing bank debits the buyer and releases the documents (including transport document), so that the buyer can claim the goods from the carrier. |
Notes:
1. The letter of credit refers to documents representing the goods - not the goods themselves.
2. Banks are not in the business of examining goods on behalf of their customers.
3. Typically the documents requested will include a commercial invoice, a transport document such as a bill of lading or airway bill, an insurance document; and many others.
Problems That You May Encounter and Tips
.Often the
seller's documents will be rejected by the banks.
The banks use limited discretion in matching the terms and conditions of the letter of credit against documents presented. There is often little room for judgement.
For example, suppose that a letter of credit describes goods as "cocoa butter with a maximum fat content of 15%". However the exporter presents a commercial invoice referring to the goods as "cocoa butter with12% fat content".
Common sense would suggest that this consignment would be accepted, yet some banks will reject the documents on the grounds of a discrepancy in the goods description.
Tip: Exporters must check the wording of all documents before submission, using the same criteria that the banks apply. Ensure that all terms used match.
.Often the letter
of credit fails to anticipate an aspect of the transaction.
For example a common requirement on a letter of credit is for a 'clean on-board bill of lading' - a document supplied by the shipping company attesting that the goods were received in apparently good condition, and were loaded in the ship's hold. However if the goods are hazardous or flammable, they will be put on the deck of the ship instead of the hold, and the bill of lading will be marked 'on deck'. This is not an on-board bill of lading, so the documents can be rejected by the bank.
Tip: To avoid such problems, exporters need an understanding of the different types of commercial document (transport document, insurance document etc.) and the things on each document that may matter to a bank in the context of presentation under a letter of credit.
..Time limits can
be missed when presenting required documents.
Tip: You must be aware of up to three time constraints - the expiry date of the credit, the latest shipping date and the maximum time allowed between despatch and presentation. Upon first advice of the letter of credit, check that all its terms and conditions can be complied with within the prescribed time limits. If the letter of credit calls for documents supplied by third parties, make reasonable allowance for the time this may take to organise. After despatch of the goods, check all the documents both against the terms of the credit and against each other for internal consistency.