Letter of Credit – Definition, Process and Types
Letters of Credit (LC), a type of credit, are widely used by businesses that engage in regular international commerce. This service serves as a payment assurance to exporters from banks and non-bank financial institutions (NBFCs). Businesses engaged in the import and export trade can rely on a Letter of Credit, a payment instrument provided by banks and non-bank financial organisations, in the event of a payment delay or default.
Internationally operating businesses sometimes interact with unnamed vendors that want payment guarantees before they get into any transactions. A Letter of Credit is a financial tool that ensures payment to import and export companies.
What is the meaning of Letter of Credit?
There are several definitions for a letter of credit, but one of them is that it is “a guarantee by the bank of the importer stating that payment would be paid to the exporter provided the required documentation is produced to the bank within the validity of the L/C.” This explains one meaning.
A business letter of credit is an agreement that is enforceable between two banks (the “issuing bank” and the “confirming or advising bank”) under which the “issuing bank” guarantees payment to the “beneficiary bank” (the “buying bank”) for goods or services the “buyer bank” has acquired (seller).Upon provision of paperwork that complies with the credit’s terms and conditions at the beneficiary’s request, the issuing Bank agrees to honour the credit with the applicant (the buyer is the individual who will eventually and lastly derive benefit from the letter of credit). As a result, the issuing Bank acts as the payment recipient on behalf of the Bank’s client.
Let’s discuss about some features of Letter of Credit:
- The Buyer’s fixed deposits, bank deposits, etc., against which the LC is issued, are examples of the Collateral/Security.
- The Bank reserve the right to charge extra costs based on the kind of Letter of Credit.
- For each Letter of Credit, the International Chamber of Commerce (ICC) publishes rules.
- The letter of credit must be accurate because there is no actual exchange of products or services throughout this transaction; just paperwork is exchanged. The seller’s name, the date, the sum, the product’s name and quantity, and other information should all be correct in the letter.
- A bank may refuse a payment if it receives incorrect information regarding the buyer, the goods, the anticipated delivery date, etc.
- Either potential defects in the latter won’t affect how much money is transferred because the only thing any parties are trading is paper and not genuine products or services.
Credit on Sight Letters of Credit in India and Different Forms
Time based Credit
In a time, credit bill of exchange, the payment is made at the conclusion of a certain time period that has been agreed upon by the lender and the borrower. This kind of credit has a deadline attached to it. Thanks to the grace period specified in the letter of credit, the borrower has a few days to repay the loan after receiving the items.
The terms and conditions of a revocable credit LC may be changed or terminated at any moment by the issuing Bank. The issuing Bank is not required to inform the beneficiaries of any changes to the letter of credit.
Credit on Sight
In order to be approved for this type of financing, a business owner just has to show a bill of exchange and a sight letter to a lender. A sight letter of credit is the quickest kind of letter of credit in terms of availability.
Standby Letter of Credit – SBLC
Importers can utilise a credit mechanism known as a Standby Letter of Credit (SBLC), which is issued by a local bank and guarantees payment to an overseas lender in the event that the borrower fails to repay the loan on time, to get foreign currency money from international lenders.
The issuing Bank must be unable to change the terms and conditions in any manner for an LC to be deemed “Irrevocable.” The letter of credit’s conditions must be followed by the Bank.
A transferable LC is one in which the beneficiary’s interests may be transferred to a third person, as the name suggests. Depending on the particular firm or sector, the specific conditions could change.
Requirements for Documentation
The beneficiary must provide the issuing bank with proof that their portion of the transaction has been completed in order to receive payment. The letter of credit specifies the kind of papers the issuing bank will accept, which frequently include:
- Bills of exchange
- Buyer receipts/Invoices
- Government documents, which includes the certificates of origin, incorporation certificate, licenses, inspection certificates, any legislations requirements from embassy, and phytosanitary certificates
- Certificates or Insurance policies, exceptthe cover notes
- Transportation and shipping documents, such as airway bills and the bills of lading
Letter of Credit Transaction Risks
Transactions involving a letter of credit are not without risk. These trades have the following risks naturally:
- Regulatory risk, which is the possibility that governmental action may stop the deal from being completed.
- Fraud risk occurs when money is paid for worthless or non-existent goods using forged or fraudulent paperwork.
- Legal risk which is the possibility that a lawsuit may stop the transaction from being completed
- Risk of force majeure, in which an external force, such as war or a natural disaster, prevents the transaction from being completed.
- failure of the collecting or issuing bankor the buyer or beneficiary’s bankruptcy
Expectations for the Letter of Credit Process
- A business transaction is concluded between the buyer and the seller. 1. As payment security, the vendor needs a letter of credit.
- A letter of credit in favour of the seller is requested by the buyer from his bank.
- The buyer’s bank issues and transmits the credit to the correspondent bank after accepting the buyer’s credit risk (advising or confirming). The location of the seller and the correspondent bank is often the same (beneficiary).
- The Advisory Bank will verify the initial credit before sending it to the seller (beneficiary).
- The seller (the beneficiary) checks and generates the appropriate paperwork criteria to support the letter of credit once the items have been sent. The paperwork required to conduct business with various firms may range significantly.
- After the Seller provides the required paperwork to the advising or confirming Bank, payment will be completed.
- The advising or confirming Bank examines the documents to make sure they comply with the terms of the letter of credit.
- If everything is in order, the advising or confirming Bank will proceed to collect the funds by performing the following:
- having the funds credited to the issuing Bank’s account.
- obtaining the required documentation and awaiting a transfer from the issuing Bank.
- As stated in the credit, reimburse on a separate bank.
- The bank giving the advice or confirmation will then forward the necessary documents to the bank issuing the money.
- The paperwork will be examined by the issuing bank to make sure everything is in order. The issuing Bank will debit the buyer’s account if everything is in order.
- The documentation is produced by the Bank and then delivered to the buyer.
The purchasing and selling procedure have gone worldwide thanks to the current generation. India now does business on a global scale with many other countries. International commercial dealings demand a high degree of faith and trust.
A letter of credit is essential since it serves as the buyer’s certificate of authenticity and keeps the buyer and seller connected during this critical phase. The main advantage of a letter of credit is that if the buyer defaults on payment, the issuing Bank will pay the full cost of the commodity.
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A letter of credit, also known as a credit letter, is an assurance from a bank that a buyer will make the right payment to a seller on time and in full. The bank will be obligated to pay the whole or remaining balance of the transaction if the buyer is unable to make a payment on it. It could be given as a service to the personnel’s or individuals.
The usage of letters of credit has developed into a crucial component of international trade due to the nature of such deals, which includes elements like distance, different regulations in each country, and difficult stances in understanding the partners or people involved.The cost to issue a letter of credit is paid by the bank. The cost of a letter of credit relies on a number of variables, including the risk level and letter of credit type.
The bank that issued the letter of credit will have to reimburse the selling if the buyer is unable to pay the entire sum due. Sometimes the seller has the option of choosing a banker, and that bank must make the payment. The seller may choose a different party to make the payment if the letter of credit is transferrable in nature.