Letter of Credit

As the term simply indicates a document (letter) pertaining to credit or loans, a Letter of Credit is issued when the seller promises the exchange of goods and services on the condition that the buyer provides acceptable credit documentation. As one of the major concepts you will come across while studying banking courses, a Letter of Credit is generally issued by banks and often renowned financial institutions as a promise that the payment will be made once the other party abides by the laid down conditions. This blog explores Letter of Credit in further detail, from its meaning, types to different elements.

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What is Letter of Credit?

A letter issued from the bank or any reputed financial institution stating that the buyer’s payment to a seller will be sent/received on the determined time for the set payment is known as a Letter of Credit. Often regarded as a facility by a bank, the chosen respective bank will bear the entire or partial cost if the buyer is unable to make the payment of the purchase. There are ample types of LOC and they vary in their nature with respect to the buyer or seller when buying or selling a product or service. Here are the major factors considered while elucidating types of LOC: 

Buyer Protection  
In this situation when the payment is made by the buyer and the company fails to provide the service or the product, then such buyers can get paid back by showing LOC. A penalty to the company that failed to deliver the product will be made and hence, the amount has to be returned. You can further use that money to avail that service/product from somewhere else.

Seller Protection
If a buyer is unable to deliver the due or entire payment of a product or service purchased, then the seller can be benefitted by the letter of credit. In such scenarios, if the seller meets all the requirements as mentioned by the bank, then the bank must pay the seller. This is an advantageous step in terms of international business as the buyers and sellers are far away. 

Recommended Read: MBA in International Business

Types of Letters of Credit 

There can be several situations between a buyer and a seller in a business environment and since the Letter of Credit aims to benefit both, there are multiple types of LOCs. Mentioned below are the popular types of credit letter:

Commercial Letter of Credit

This can be considered as the direct or primary payment method when the beneficiary receives payment from the issuing bank.

Standby Letter of Credit

It is known as the secondary method of payment, wherein the beneficiary gets paid by the bank only if the holder cannot.

Traveller’s Letter of Credit 

Through this letter, the respective bank will guarantee that they will honour the draft made at any reputed foreign bank. 

Revolving Letter of Credit 

Out of all the types of LOCs, the customer has multiple numbers of draws within a determined limit and in a fixed time period for a Revolving Letter of Credit.  

Confirmed Letter of Credit 

There are two banks involved in a confirmed letter of credit. Firstly, the issuing bank guaranteeing the letter of credit along with another bank. Out of these two, the second bank is called the confirming bank which will be directly in touch with the seller and will be the seller’s bank. The confirming bank will make sure that the payment is made via the LOC if in any case the issuing bank and the holder defaults.

Transferable Letter of Credit

As the name suggest, in this the letter of credit is transferable that allows the first beneficiary to transfer another party with  some or all of the credit creating a secondary beneficiary.

Revocable Letter of Credit

This is the least used letter of credit because it allows the issuing bank with the right to make changes in the letter of credit at any point without informing the seller

Irrevocable Letter of Credit

In this type, anything can not be changed by the issuing bank in the letter of credit without conseting the selling party

Back to Back Letter of Credit

In this type, letter of credit includes majorly two letters securing a single transaction. These are used in international trade or transactions for intermediary transactions between the buyer and seller.

Red Clause

In this letter of credit Is a type of credit beneficiary has the righ to access the credit before the shipment of goods and without presenting any documents.

Green Clause

In this letter of credit,  beneficiary can enjoy some amount of advance by lodging the shipment products as storage under bank security.

Unconfirmed Clause

In this type, the letter of credit is issued without the guaranteed or confirmation by a secondary bank. Most of the letter of credits are Unconfirmed clause.

Sight Letter of Credit

In this type, seller only receives the payment after the shipment is received by the buyer and seller has proved all the appropriate documents and evidenced. Only after reviewing the payment is given to the buyer.

Deferred Payment/ Usance Letter of Credit

In this type, LC states the payment will be not given immediately. The seller will receiver a payment after a certain period of time mentioned in the letter of credit. The issuing bank may review the documents early but the payment is made only after the agreed upon time.

Direct Pay Letter of Credit

In this type, the bank pays the seller and then the bank receives the payment from the buyer. In this type, there is no contact of payment between buyer and seller.

Letter of Credit Example

To understand the concept of LC better, here is an example that will explain the purpose, use and benefits of lc:

Elements of LC

The LOC consists of the following major elements indicating the issuing party, the seller and the buyer as well as goods and services, amongst others.

• Issuing Bank 
• Beneficiary 
• Applicant 
• Intermediary 
• Freight Forward 
• Advising Bank
• Legal Counsel, etc. 

Related Read: How to Become a Bank Manager?

Documents Required 

Now that you understand the concept of LC, let’s go through some of the essential documents required for it. However, a uniform format of the LOC can not be determined as it varies from bank to bank. 

• Invoices 
• Shipping and transport documentation 
• Insurance policies or certificates 
• Official documents like license, inspection certificate, etc 
• Bills of exchange 

LC in Payment Terms

There are certain terms and conditions to be fulfilled at the time of letter of credit is issued. Here is the list of LC in payment terms:

• The buyer and the bank issuing the LC should confirm the LC.
• The delivery date or product and the payment receiving date should be mentioned clearly in the LC.
• Guarantee commitment should be mentioned specifically stating the percentage and risk with the amount and should be clear and accurate.
• All the relevant and important information should be written in the export agreement.

How to apply for Letter of Credit?

Wondering about the process of a Letter of credit or how does it work? We have made it easy for you to understand. Here is a stepwise application process of the letter of credit:

1. Buyer and seller selects the bank for issuing the letter of credit and the advising bank that can be any international or national bank for seller.
2. The seller will receive the letter of credit at the secondary bank probably in his/her home country. Secondary or advising bank will also check the details on the letter.
3. The assurance is goven to buyer about the payment because of the agreement between the buyer and seller. Goods are then shipped to the buyer. 
4. Seller will receive a receipt or bill which will be a proof of evidence of the shipment of products.
5. After presenting the bill to the issuing bank, seller will receive the payment after the documents are verified.

Why is Letter of Credit Important?

Wondering why is it important to have a letter of credit. Here are all the reasons why:

• It reduces the risk of payment and provides assurance to the buyer this helps manufacturers to sell their products all around the world.
• With it, the payment is assured. Incase, a seller is unable to pay due to uncertain reasons the issuing bank will pay the agreed uopn amount to the seller.
• It gives authentication to both buyer and seller and also makes both parties more credible. 
• It is flexible to customization in between buyer and seller with consent and can add mutual clauses as per requirement.

Advantages & Disadvantages of a Letter of Credit

Let’s focus on some of the main advantages and disadvantages of a letter of credit as mentioned below.

Advantages	Disadvantages
It provides complete security for buyer and seller.	There’s a need of different letter of credit for different transactions.
The Bank takes full responsibility, financially, of the buyer.	It is tedious, expensive, and time consuming.
There’s guaranteed payment that allows seller to borrow against full value from the lender.	Need of more paperwork for seller.

Things to Remember

Altough there are many added advantages benefitting both buyer and seller, Here is the list of things that both entities should take into consideration:

1. Review and evaluate every clause before agreeing upon anything in the letter of credit.
2. Always ensure you have the mandatory documents required in the letter of credit.
3. Understand the due date and time limits mentioned in the letter of credit.

FAQs

Thus, we hope that through this blog, you are familiarised with the Letter of Credit and its essential features and types. Planning to pursue a career in Finance or Banking? Reach out to our Leverage Edu experts and we’ll guide you in selecting a suitable course and university that can equip you with the necessary knowledge and exposure to build a rewarding career in your chosen field. Sign up for an e-meeting today!