Banking Instrument (SBLC) 101 ( Part 1)
Eugene Edwards
Eugene M. Edwards is a Financial Services Consultant at Eugene M Edwards ICS
Letter Of Credit?(Explained)
A letter of credit is a bank’s written promise that it will make a customer’s (the holder) payment to a vendor (called the beneficiary) if the customer does not.
Examples of Letters of Credit
Letters of credit are most common in international transactions, where buyers and sellers do not have an established relationship or laws and conventions may make certain transactions challenging. I’ll give an example, let’s assume that Company Beta$ sells widgets in Chicago and Company Alpha€ manufactures widgets in Germany. Company Beta$ wants to import $100,000 worth of widgets manufactured by Company Alpha€, but Company Alpha€ is concerned about Beta$’s ability to pay for them.
To address this, Company Beta$ gets a letter of credit from its bank, Bank of Chicago, indicating that Company Beta$ will make good on the $100,000 payment in, say, 60 days, or Bank of Chicago will pay the bill itself. Bank of Chicago then sends the letter of credit to Company Alpha€, which then agrees to ship the widgets.
After the shipment goes out, Company Alpha€ (or Company Alpha€’s bank) then ask for its $100,000 by presenting a written draft (also called a bill of exchange) to Bank of Chicago. Although letters of credit mostly benefit sellers, they also protect buyers, because Company Alpha€ must present Bank of Chicago with written proof of the widget shipment in order to get paid. This proof usually includes a commercial invoice, bill of lading, or an airway bill. After Bank of Chicago pays Company Alpha€, it turns to Company Beta$ for reimbursement (usually by debiting Company Beta$’s bank account).
Banks would usually require a pledge of securities or cash collateral in order to issue a letter of credit to a holder. Banks also collect a fee for issuing letters of credit; the fee is usually a percentage of the size of the letter of credit. The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits governs letters of credit used in international transactions. In the United States, the Uniform Commercial Code governs letters of credit used for domestic transactions.
There are several kinds of letters of credit:
A?commercial letter of credit?is one of the most common and is reflected in the example above. This kind of letter acts as the primary payment mechanism between the customer and the beneficiary; that is, the issuing bank makes the actual payments to the beneficiary every time. So in our example above, Bank of Chicago pays Company Alpha€ directly, even if Company Beta$ has the cash and the means to fulfil its obligation to Company Alpha€.
A?standby letter of credit, on the other hand, is a secondary payment mechanism, meaning that the bank pays the beneficiary only when the holder cannot. Both parties to a standby letter of credit never hope to have to use it. In our example above, the Bank of Chicago would only pay Company Alpha€ directly if Company Beta$ couldn’t.
A?revolving letter of credit?lets the customer make any number of draws for a certain period as long as they do not exceed a certain limit.
A?traveller’s letter of credit?is a promise that the issuing bank will honour drafts made at certain foreign banks.
A?confirmed letter of credit?is a letter of credit that has another bank beside the issuing bank standing behind it. This second bank is called the confirming bank, and it is usually (but not always) the seller’s bank. The confirming bank ensures payment under the letter of credit if the holder and the issuing bank default on the letter of credit. This is usually done at the request of the issuing bank in international transactions.
Letters of credit are usually negotiable instruments, meaning that the issuing bank must pay the beneficiary or any bank nominated by the beneficiary. In some cases, letters of credit are also transferable, meaning that the beneficiary has the right to assign the right to draw to another entity (such as a corporate parent or even a third party).
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Why do Letters of Credit matter?
A letter of credit is a tool to reduce risk — it essentially substitutes the bank’s credit for the customer’s credit and helps facilitate international trade.
It is important to note that a letter of credit is not the same as a bank guarantee, although with both instruments the issuing bank accepts a customer’s liability if the customer defaults. With a guarantee, the seller’s claim goes first to the buyer, and if the buyer defaults, then the claim goes to the bank. With letters of credit, the seller’s claim goes first to the bank, not the buyer. Although the seller will probably get paid in both cases, letters of credit offer more assurance to sellers than guarantees generally do.
Dealing with bank instruments such as Letter Of Credit, Standby Letter Of Credit and?Bank Guarantee?can be quite tricky this is why you must talk to a financial expert with years of experience when it comes to matters like this.
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Eugene Edwards SBLC
Contact: Dr Eugene M. Edwards