letter of credit (L/C)
(banking) Formal term: Documentary credit or documentary letter of credit.
A letter of credit is a document issued by a bank stating its commitment to pay someone (supplier/exporter/seller) a stated amount of money on behalf of a buyer (importer) so long as the seller meets very specific terms and conditions. Letters of credit are more formally called documentary letters of credit because the banks handling the transaction deal in documents as opposed to goods.
The terms and conditions listed in the credit all involve presentation of specific documents within a stated period of time, hence the formal name–documentary credits.
The documents the buyer requires in the credit may vary, but at a minimum include an invoice and a bill of lading. Other documents the buyer may specify are certificate of origin, consular invoice, insurance certificate, inspection certificate and others.
Letters of credit are the most common method of making international payments, because the risks of the transaction are shared by both the buyer and the supplier.
Documentary letters of credit are subject to the Uniform Customs and Practice for Documentary Credits (UCPDC), Brochure No. 500, of the International Chamber of Commerce (ICC) in Paris. See Uniform Customs and Practice.
Basic Letters of Credit
There are two basic forms of a letter of credit: the Revocable Credit and the Irrevocable Credit. There are also two types of irrevocable credit: the Irrevocable Credit not Confirmed, and the Irrevocable Confirmed Credit. Each type of credit has advantages and disadvantages for the buyer and for the seller. Also note that the more the banks assume risk by guaranteeing payment, the more they will charge for providing the service.
(a) Revocable credit–This credit can be changed or canceled by the buyer without prior notice to the supplier. Because it offers little security to the seller, revocable credits are generally unacceptable and are rarely used.
(b) Irrevocable credit–The irrevocable credit is one which the issuing bank commits itself irrevocably to honor, provided the beneficiary complies with all stipulated conditions. This credit cannot be changed or canceled without the consent of both the buyer and the seller. As a result, this type of credit is the most widely used in international trade. Irrevocable credits are more expensive because of the issuing bank’s added liability in guaranteeing the credit. There are two types of irrevocable credits:
(1) The Irrevocable credit not confirmed (Unconfirmed credit). This means that the buyer’s bank which issues the credit is the only party responsible for payment to the supplier, and the supplier’s bank is obliged to pay the supplier only after receiving payment from the buyer’s bank. The supplier’s bank merely acts on behalf of the issuing bank and therefore incurs no risk.
(2) The Irrevocable, confirmed credit. In a confirmed credit, the advising bank adds its guarantee to pay the supplier to that of the issuing bank. If the issuing bank fails to make payment, the advising bank will pay. If a supplier is unfamiliar with the buyer’s bank which issues the letter of credit, he may insist on an irrevocable confirmed credit. These credits may be used when trade is conducted in a high risk area where there are fears of outbreak of war or social, political, or financial instability. Confirmed credits may also be used by the supplier to enlist the aid of a local bank to extend financing to enable him to fill the order. A confirmed credit costs more because the bank has added liability.
Special Letters of Credit
There are numerous special letters of credit designed to meet specific needs of buyers, suppliers, and intermediaries. Special letters of credit usually involve increased participation by banks, so financing and service charges are higher than those for basic letters of credit. The following is a brief description of some special letters of credit.
(a) Standby letter of credit–This credit is primarily a payment or performance guarantee. It is used primarily in the United States because U.S. banks are prevented by law from giving certain guarantees. Standby credits are often called non-performing letters of credit because they are only used as a backup payment method if the collection on a primary payment method is past due.
Standby letters of credit can be used, for example, to guarantee the following types of payment and performance:
repayment of loans,
fulfillment by subcontractors,
securing the payment for goods delivered by third parties.
The beneficiary to a standby letter of credit can draw from it on demand, so the buyer assumes added risk.
(b) Revolving letter of credit– This credit is a commitment on the part of the issuing bank to restore the credit to the original amount after it has been used or drawn down. The number of times it can be utilized and the period of validity is stated in the credit. The credit can be cumulative or noncumulative. Cumulative means that unutilized sums can be added to the next installment, whereas noncumulative means that partial amounts not utilized in time expire.
(c) Deferred payment letter of credit– In this credit the buyer takes delivery of the shipped goods by accepting the documents and agreeing to pay the bank after a fixed period of time. This credit gives the buyer a grace period for payment.
(d) Red clause letter of credit–This is used to provide the supplier with some funds prior to shipment to finance production of the goods. The credit may be advanced in part or in full, and the buyer’s bank finances the advance payment. The buyer, in essence, extends financing to the seller and incurs ultimate risk for all advanced credits.
(e) Transferable Letter of Credit–This credit allows the supplier to transfer all or part of the proceeds of the letter of credit to a second beneficiary, usually the ultimate supplier of the goods. This is a common financing tactic for middlemen and is used extensively in the Far East.
(f) Back-to-Back Letter of Credit–This is a new credit opened on the basis of an already existing, nontransferable credit. It is used by traders to make payment to the ultimate supplier. A trader receives a letter of credit from the buyer and then opens another letter of credit in favor of the supplier. The first letter of credit is used as collateral for the second credit. The second credit makes price adjustments from which come the trader’s profit. See Guide to Letters of Credit Appendix.