Letter of Credit

LETTER OF CREDIT

A letter of credit (LC), also known as a documentary credit or bankers commercial credit, is

a payment mechanism used in international trade to provide an economic guarantee from a
creditworthy bank to an exporter of goods.

A contractual agreement between banks (issuing bank), on behalf of one of its customers,
authorizing another bank (advising or confirming bank), to make payment to the beneficiary. The
issuing bank, on the request of its customer, opens the letter of credit. The issuing bank makes a
commitment to honor drawings made under the credit. Essentially, the issuing bank replaces the
bank's customer as the payer.

Elements of a Letter of Credit:

 A payment undertaking given by a bank (issuing bank)

 On behalf of a buyer (applicant)
 To pay a seller (beneficiary) for a given amount of money
 On presentation of specified documents representing the supply of goods
 Within specified time limits
 Documents must conform to terms and conditions set out in the letter of credit
 Documents to be presented at a specified place

Types of Letter of Credit:

1. Documentary letter of credit:

 Documentary Credits are the preferred method of payment:
Where there is a customer credit risk, country risk- (risk of political or economic factors
interfering with settlement of debts)and control (especially shortage of foreign exchange).
  Buyer is assured that his bank will only pay to the seller if seller’s documents comply
with all the terms & conditions of the credit (advantage to buyer).
 Banks deal only with documents and not with goods (risk of buyer).
2. Commercial letter of credit:
Some of the most commonly used LC’s are;
 Back-to-Back letters of credit:
These are typically used by an intermediary trader as a pledge to his bank in exchange
for an identical credit in a lesser amount in favor of the trader’s supplier.
 Transferable letters of credit:
These are an alternative to back-to back letters of credit and are widely used where
intermediaries or middlemen need to offer secure terms to their suppliers.
Under this arrangement the beneficiary of a letter of credit is allowed to transfer his right
to perform under the master credit without the need for establishing another credit.

Procedure

 Buyer and seller agree to conduct business. The seller wants a letter of credit to
guarantee payment.
 Buyer applies to his bank for a letter of credit in favor of the seller (Set up the LC
correctly – negotiating all points).
 Buyer's bank approves the credit risk of the buyer, issues and forwards the credit
corresponding bank (advising or confirming). The correspondent bank is usually located
in the same geographical location as the seller (beneficiary).
 Advising bank will authenticate the credit and forward the original credit to the seller
(beneficiary).
 Seller (beneficiary) ships the goods, then verifies and develops the documentary
requirements to support the letter of credit. Documentary requirements may vary greatly
depending on the perceived risk involved in dealing with a particular company.
 Seller presents the required documents to the advising or confirming bank to be
processed for payment.
  Advising or confirming bank examines the documents for compliance with the terms
and conditions of the letter of credit.
 If the documents are correct, the advising or confirming bank will claim the funds by:
Debiting the account of the issuing bank, waiting until the issuing bank remits, after
receiving the documents and reimburse on another bank as required in the credit.
 Advising or confirming bank will forward the documents to the issuing bank.
 Issuing bank will examine the documents for compliance. If they are in order, the
issuing bank then forwards the documents to the buyer. If incorrect, reject the LC
immediately. If necessary, request the buyer amend the Letter of Credit

LC Cycle:

Independence Principle:
LC Screening:

Screening in LC & Trade documents: