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LETTER OF CREDIT - How it Guarantees Payment for Exporters

Updated: Dec 8, 2023

Letter of Credit (LC) is a financial instrument which is used in domestic and cross-border trade. It is a written commitment by a bank on behalf of its client (buyer or exporter) to another bank (seller or importer) that the payment will be made as per the terms & conditions of Letter of Credit. In other words, LC represents guarantee by buyer’s bank to seller’s bank ensuring payment on due date even if the client (buyer or importer) fail to do so.

Letter of credit is widely used in international or global trade where both the parties i.e., buyer and seller are unfamiliar with each other, it becomes important to demonstrate creditworthiness of the concerned party.

For instance, Mr. A is an importer in India and Mr. B wishes to export from US goods to Mr. A. The terms of contract are such that Mr.A will make payment for goods after one month of receipt of delivery. However, Mr. B is unfamiliar with Mr. A and concerned whether goods should be supplied or not. Here, Mr. B can asks for Letter of Credit from Mr. B to eliminate risk of default by Mr. A. Practically the steps will be :

1. Mr. A goes to his bank SBI

2. Either Mr. A will already have Sanctioned Credit Limit with his bank on basis of his earlier business relation and security he has already given or else Mr. A will keep the Fixed Deposit as Pledge as security with the bank for an amount equivalent to the value of goods he is purchasing

3. Then SBI (Bank of Mr. A) will issue a Letter of Credit (LC) to the Bank of Mr. B.

4. If Mr. A doesn’t pays for goods within one month than Bank of Mr. A is obliged to pay to Bank of Mr. B.

5. Thus in this manner credit risk of default by Mr. A is mitigated in this international transaction of import and export.

Features of Letter of Credit

1. Collateral: Letter of credit is issued against collateral or cash margins or sanctioned credit limits by the bank.

2. Conditional Responsibility: In Letter of Credit, the primary responsibility of making payment lies with the buyer and bank has a conditional responsibility i.e., only if buyer is unable to do so, the bank will pay to the seller.

3. Possession of Goods: Until and unless the buyer makes full payment to the seller or the bank, whatever the case may be, the bank does not release the goods and takes full responsibility of them.

4. Fee: Bank charges particular fee for the documentation and issuance of Letter of Credit to the buyer.

5. Customized: LC can be tailored as per the needs of parties involved and circumstances of transaction.

6. Time Consuming: Availing LC facility is a time-consuming process as numerous parties are involved in the process.

There are different types of letters of credit that are issued in different situations or for different purposes. Five major types are Commercial LC, Standby LC, Revolving LC, Traveler’s LC and Confirmed LC.

Cost involved in Letter of Credit

Letter of credit comprises cost in the form of fee, documentation charges and other related charges. Banks usually charges fee as a percentage of total amount that is guaranteed by the bank. However, cost differs as per lender, buyer and type of LC.

For instance, SBI has the following LC Confirmation charges on the basis of credit rating of the buyer:

AAA-AA/Aaa: 0.25% pa

A-Baa3/BBB/A1-1/A3: 0.50% pa

Ba1-B3/BB/B: 0.75% pa

Unrated charges: 0.75% pa

How Letter of Credit works?

1. Buyer and seller into a trading agreement or contract and the seller requests LC from buyer.

2. Buyer requests LC from bank (Issuing Bank) in favour of seller. Issuing bank approves buyer’s request, issues LC and send it to the seller’s bank (Advising Bank).

3. Advising Bank will authenticate LC and informs seller.

4. Seller sends the goods and perform documentation such as invoices, insurance certificate, etc as per the LC terms and conditions and present the same to advising bank.

5. Advising bank will check the documents and forward them to issuing bank for payment.

6. Issuing bank will also verify the documents and if everything seems appropriate and as per LC terms & conditions, bank will ensure payment and the payment will be made from buyer’s bank account on due date.

7. Finally, buyer takes the possession of goods.

Letter of Credit can be really helpful in any domestic or international trade. It is flexible in nature which makes it easier to be used. However, buyer and seller both needs to perform due diligence and be aware of all terms and conditions while dealing with Letter of Credit.

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