Letter of Credit – Working, Process to Apply, Types and Examples
What is a Letter of Credit?
A letter of credit or credit letter is a bank-issued document that guarantees a seller will receive full payment from a buyer on time. Financial institutions also issue this document in exchange for security or cash. Usually, banks collect a fee that is a percentage of the amount of the credit letter. It is an essential document while trading internationally. International trade involves aspects like distance, different laws of both countries lack of face-to-face contact, and much more. To smooth out this complicated process, a bank issues a credit letter.
This blog decodes all the questions about the Letter of Credit and its functions. Read to know more!
How Does a Letter of Credit Work?
The process of a Letter of Credit is not as tedious as it seems:
- Issuing the Letter of Credit
A LOC is issued by the importers bank. The importer applies to the issuing bank to issue a LOC in favor of the exporter after the parties to the trade agreement on the contract and the use of LOC. The issuing bank transmits the LOC to the advising bank. The latter is usually located in the country of the exporter and may even be the exporter’s bank. The advising bank (confirming bank) validates the LOC and sends it to the exporter.
- Shipping of Goods
After receiving the LOC, the exporter is required to verify the documents to ensure their authenticity and begin the goods shipment process.
- Submit the Documents to the Advising Bank
Following the shipment of the goods, the exporter ( directly or through freight forwarders) submits the documents to the advising/confirming bank.
- Payment Settlement and Goods Possession
In turn, the bank sends the documents to the issuing bank, where the amount is paid, accepted, or negotiated, depending on the circumstances. The issuing bank approves and verifies the documents and collects payment from the importer. Then it forwards the documents to the importer, who then uses them to take possession of the shipped goods.
Example of Letter of Credit
For example, Mr. E (an Indian exporter) has a shipment of goods contract with Mr. F (a US importer). Both parties, who are strangers to each other, agree to a LOC arrangement. Mr. E is assured that he will be paid by the buyer, and Mr. F is assured that he will have a systematic and documented process in place, as well as evidence that goods have been shipped.
This is how a Letter of Credit will work between the two parties:
- Mr. F (buyer) requests the issuing bank to issue a letter of credit on his behalf
- The issuing bank then processes the LOC to the advising bank (Mr. E’s Bank)
- The advisory bank verifies the LOC’s legitimacy before sending it to Mr. E
- Now that Mr. E receives the confirmation, he will ship the items and, together with other required paperwork, will get a Bill of Lading. He then sends the documents to the negotiating bank.
- The negotiating bank will ensure that all conditions are met and will then pay Mr. E as a result (the seller).
- The negotiating bank will also transmit the required paperwork to the issuing bank.
- Again, Mr. F (the buyer) will receive a copy of this from the issuing bank to validate its legitimacy.
- Mr. F will pay the issuing bank after receiving confirmation.
- Furthermore, the issuing bank will transfer the funds to the negotiating bank.
Also Read
What are the Different Types of Letters of Credit?
There are mainly four types of letters of credit:
1. Revocable
The terms and conditions of a letter of credit that is revocable can be changed or revoked by the bank that issued it. Beneficiaries do not need to be informed of any changes to the letter of credit by the issuing bank.
2. Irrevocable
The issuing bank cannot change or cancel the terms and conditions of an irrevocable credit. The bank is required to follow the instructions or commitments stated in the letter of credit.
3. A Standby Letter of Credit
An importer can get foreign currency funds abroad through the Standby Letter of Credit (SBLC), a credit mechanism in which the domestic bank issues an SBLC that ensures payment to the foreign bank in the event that the borrower fails to make the required repayments by the due date.
4. Credit on Sight
In this type of credit, an entrepreneur can present a bill of exchange with a sight letter to the lender and receive funds immediately on the basis of the sight letter. A sight letter of credit is the quickest letter of credit that can be obtained.
5. Transferable
As the name implies, transferable credit is a type of LC in which the beneficiary can transfer his or her rights to third parties. The terms and conditions may vary depending on the trade and industry.
Benefits of a Letter of Credit
Following are the benefits of a letter of credit:
- It allows a trade partner to trade with unknown partners. Moreover, it helps expand one’s business to new foreign locations.
- A credit letter is like a contract that enables trading partners to back out from the deal in case of disputes. Besides, an exporter can withdraw funds as agreed upon in a credit letter.
- This financial document is highly beneficial to a seller if an importing company goes bankrupt. Since a credit letter transfers an importer’s creditworthiness to the issuing bank, the financial institution has to pay a seller on behalf of the importer.
- Both trading parties, an importer and exporter, can customise a contract based on their requirements. Further, they can change the clauses from one transaction to another.
- The court describes the right to the total amount in the phrase “pay now, litigate later”.
Disadvantages of Letter of Credit
While a credit letter is beneficial for buyers and sellers, there are a few disadvantages too. They are as follows:
- It increases bank charges for this service. Moreover, credit letter charges increase steeply if either party wants to put in some additional features.
- The life cycle of a credit letter has an expiration date. As a result, an exporter has to export all products within a given time period, which could result in a mess.
- It can give way to material fraud risk. A bank will pay a seller based on its shipment documents and not based on a product’s quality. Later, disputes can arise if the quality is different from what was agreed upon initially.
- Using a letter of credit can result in delays and other administrative issues.
- The issuing bank is responsible for the Letter of Credit’s payment reliability.
How is a Letter of Credit Issued?
A letter of credit is issued by following the below steps:
Step 1: The buyer approaches a bank for issuing a credit letter. This chosen financial institution becomes the issuing bank.
Step 2: The beneficiary or seller will also have an advising bank on their team. Usually, these advising banks are international banks that check a document’s authenticity on behalf of the seller.
Step 3: The advising bank will keep the credit letter with them. This will assure the seller that he/she will receive money no matter what, as banks are now involved in the process.
Step 4: The seller will ship products as per terms both the seller and buyer and mutually agreed upon. Furthermore, the seller will receive a bill of lading as the entity has already exported goods.
Step 5: The buyer now has to present a bill of lading to the nominated bank (international bank) that will review all the shipping documents. If the nominated financial institution finds that all regulations are met, it will pay the seller.
Step 6: The nominated bank will send over shipping documents to the issuing bank and ask for the money the bank had spent on paying the seller.
Step 7: Next, the issuing bank will share all the documents with the importer. Moreover, this bank will seek approval from the importer and ask them if all documents are correct as per their knowledge and if all products are shipped or not.
Step 8: Finally, the importer gives money to the issuing bank, which pays the nominated bank.
List of Banks and NBFCs Offering Letter of Credit
Below is the list of banks offering LOC:
- SBI
- Kotak Mahindra Bank
- ICICI Bank
- Punjab and Sind Bank
- IDBI Bank
- HDFC Bank
- Axis Bank
- Union Bank of India
- Lendingkart Finance
- DBS
- Bandhan Bank
Also Read
Documents Required for Letter of Credit
- Fill the application form with passport-sized photographs
- KYC of the applicant, co-applicants, partners, directors
- 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 the buyer’s/seller’s country
- Any other document required by the lender
How Does a Letter of Credit Help Buyers?
Generally, a credit letter is known to help a seller during international trade and exchange. This is because a bank will ensure that the seller receives money from the buyer or an issuing bank. However, this monetary document is also beneficial for the buyer when the buyer has already made the payment, and the seller has delayed the shipment. In a situation like this, the buyer will get paid back the money that he or she had spent on making the credit letter.
A seller will have to pay a penalty when the importer receives the refund. Additionally, with the help of a refund, a buyer can now purchase the same products from another party.
How Does a Bank Get Money for a Letter of Credit?
A bank enters into a contract with a buyer and a seller in the event of a credit letter. In accordance with this agreement, if the exporter is unable to complete the payment on time, the bank is required to make a payment to the seller on behalf of the buyer. Also, a bank that gives a credit letter will only do so if it is confident that the buyer will be able to pay the seller. A buyer must therefore pay the bank directly. Nonetheless, both the buyer and the seller must sign a confirmation letter if the seller is unsure that an issuing bank will no longer be able to make payments in the future. In this case, another bank will guarantee for the issuing bank.
Final Word
A letter of credit helps in minimising all risk factors during international trade and exchange. Moreover, it helps one manage cash flow as an importer does not need to make payments during the initial stages of a deal. Hence, this financial document is beneficial for both importers and exporters.
Ready to take the next step towards your financial goals? Apply for Navi Cash Loan in a 100% paperless manner at affordable rates and get the funds you need to achieve your dreams!
FAQs
Yes, a bank will charge a fee while issuing a credit letter. Typically, most banks charge half per cent of the actual amount that a buyer needs to pay to a seller. Moreover, fees depend on multiple factors like risk amount, etc.
A bank guarantee is a promise that it will step up if a debtor cannot pay their debts. On the other hand, a credit letter is a financial document that promises that it will pay on behalf of a buyer to a seller if the former fails to make payment.
The duration of getting a credit letter from a bank depends on the issuing bank. Usually, the approval process takes around 10-15 days. However, the time might increase depending on various factors. Moreover, a bank’s relationship with its client is also a huge factor in getting a credit letter as soon as possible.
An issuing bank can ask its client for collateral if they have doubts about that client’s finances. One can keep fixed deposits as collateral. That said, the final decision will be of the banks, whether they want to enter into the transaction or not.
Citibank is well known for offering credit letters to buyers from Africa, Asia, Eastern Europe, Latin America and the Middle East. This is for buyers who have faced problems while obtaining international credit on their own. It helps minimise the importer country’s risk, and it also reduces issuing bank’s commercial credit risk.
Like the guarantee, the Standby Letter of Credit (Standby LC) is frequently used to offset the risk of a contract party failing to uphold agreed-upon responsibilities, including failing to pay or deliver.
A letter of credit is simply a contract between a beneficiary, a bank, and the bank’s client. The letter of credit, which is often issued by an importer’s bank, assures the beneficiary that payment will be made once the terms of the letter of credit have been satisfied.
A revocable letter of credit is one that the issuing bank may cancel or change at any time without notifying the beneficiary or getting their permission.
Personal Loan in Your City
