Meaning of Letter of Credit (LC)
A letter of credit (LC)is a financial acclaim issued by the bank as a guarantee letter for the payment issued to the buyer. It sanctions the quoted amount and ensures the timely commitment of the payment to a seller. It is the most customary mode of payment for international goods trading.
The letter is a constitution of three entities; the bank, the business owner and the trader. It secures both the avenues of buyer’s and seller’s perspective. The buyer has the credit to purchase the goods and impart the requisite services while assuring the customer of its timely payment as well. It helps in the smooth functioning of the business operations.
Types of Letter of Credit (LC)
There are different types of financial contracts issued by the bank authorities. Their acceptance varies according to the different markets and functioning of the business. One of them is a Letter of Credit. Different types of letter of credit have their own features and are used during different business scenarios. The major two types being inland or domestic LC and Import/Export LC. As the name suggests the former is related to trades happening within the domestic borders and the latter relates to export and import of goods. The various types of letters of credit are defined hereunder.
Commercial Letter of Credit (LC)
The commercial letter of credit is termed as the export LC or the import LC. The financial letter of credit can either be used for import or export trading purposes by the importer or exporter respectively.
Standby LC (SBLC)
It is a financial contract made in the favor of the seller by the buyer’s bank authorities. It is called the standby letter or credit as it acts as a standby mechanism of payment to the seller when the buyer fails to do so. It is an alternative plan set aside in case of payment failure by the buyer and is initiated by the bank authorities.
Back-to-Back Credit LC
It is an intermediary letter of credit issued for the non-disruption of the trading services. It is intended to be used when one of the suppliers fails to deliver the goods and services for any reason and a second credit is issued to another seller to deliver the unfulfilled services. Such types of credit letters are used for various trading houses.
Transferable LC
A transferable letter of credit is utilized as an added financial assistance in which the bank transfers the money. There is an aforementioned amount approved in the letter of credit to be given to another seller at the request of the original seller or beneficiary.
Revocable LC and Irrevocable LC
The revocable letter of credit and irrevocable letter of credit is bound by the varying terms and conditions issued by the seller to the seller. The revocable LC has terms and conditions that are subject to change or cancellation at any point in time by the bank. No prior notice shall be given to the added beneficiaries. An irrevocable credit letter is under the restraint of terms and conditions of the bank which cannot be changed or cancelled as committed to the seller.
Usance Letter of Credit or Sight LC
The sight or the usance letter of credit is the guaranteed approval of payment issued to the seller after the presentation of the required documents by the bank.
Revolving Letter of Credit/ LC
It is a financial letter consisting of an approved credit amount for multiple freights. This LC is on renewable terms for increasing the credit limit or for the available timeline. This is beneficial for sending shipments regularly in case of the same sellers.
Confirmed Letter of Credit/ LC
Confirmed LCs are issued when there is financial insecurity regarding the issuing bank or terms and conditions of the country. There are consents taken from the advising banks to confirm the credit payments to the seller from the issuing bank. The advising bank becomes the main bank for crediting the payment to the seller for being an additional security benefit.
Letter Of Credit Explained
Eligibility for Letter of Credit
The following eligibility criteria should be met for the issuance of a letter of credit:
- The turnover of the company is Rs 500 crores and above.
- The board of directors should approve and support the credit and payment guarantees agreed upon on behalf of the joint stock companies.
Documentation Required for a Letter of Credit
A letter of credit is issued by the bank authorities by presenting some required documents that permit the use of the approved payments.
Following is the list of documents that need to be prepared:
- General undertaking duly signed and stamped.
- A deposit letter to be written on a letterhead by the depositor of the business enterprise
- Import/Export Code to be presented (IEC)
- OGL cum FEMA declarations
- Deed of partnership for companies as formed in case of the partnership firms or by board of resolutions
- The invoice or the purchase order
- FOB (free on board)and C&F (cost of the freight of the goods) criteria under an insurance cover whose details should be presented
- Annexure of the letter of credit covering all the details
- Cargo shipment through any transport mediums (airways, railways, or road) invoice documentation details required.
Fees associated with a Letter of Credit
There are some fees associated with the letter of credit that need to be considered such as:
- Documentation Fees
- Processing Fees
- Temporary overdraft charges (TOD)
- Overdue/Penalty charges
- Commitment charges
- Collateral charges
- Foreclosure charges
- Subsidy charges
- Certificate fees
- Collateral swap fees
Importance and Need of Letter of Credit
The business operates on both ends as a vendor and as a seller. The credit payment letter is the most integral part of running a successful business and catering to the international market. It works as a security in international trading and a guaranteed payment tool in the domestic market for a business in terms of money circulation and operations.
The International Chamber of Commerce publishes the Uniform Customs and Practices for Documentary Credits (UCP). This is aimed to set a global standard and norms for the use of letter of credit for international trades. lets look at the importance and need for LC.
Importance of Letter of Credit
- It manages the financial distance between the buyer and seller in the business
- It acts as the major source and medium of international deals
- It helps the payment backstops between a buyer and sellers
- It works well in favour of abiding by the different trading laws of the countries
- It helps in building trust within businesses creating a smooth flow of work
Need for Letter of Credit
- It aids in business expansion both at national and international levels. This provides an edge to flourish and prosper in new landscapes with existing business partners or newly established relationships.
- It is a customized documentation with differing terms and conditions serving as an assurance within the businesses. It acts as a mutual set of clauses agreed between a trader and the customer with crediting amounts, number of transactions (to one or more sellers), and timeframe.
- Flowing credit to a business on fulfilling terms is an added asset to international trading. The issuing bank of the buyer checks all the creditability of the necessary documents concerning the business and the two parties before issuing the credit. The issuing bank is independent of any obligations by offering the two parties its desirable terms.
- It is a credit certificate which improves the creditworthiness of the buyer or the business owners or importer to maintain the credit limit, re-issue, or worthiness within the exporters and sellers.
- It acts as a shield to a seller in case the buyer is into any form of financial crisis. Any financial loss or bankruptcy at the buyer’s end will not put the seller at any risk of not getting the payment. The credit issuing bank authorities are under the obligation of the letter of credit for paying the concerned amount to the seller.
- It serves as a financial claim by the seller in case of any payment dispute between the vendor and seller. The letter of credit abides under the clause of ‘pay now and litigate later’ in the formed terms and conditions document of the letter of credit. The buyer cannot withhold or deny the payment on the terms of low-quality goods as the letter of credit stands as an obligation to the bank and buyer that needs to be fulfilled to the seller.
Example
For instance, Citibank is the branch that offers the letter of credit in countries such as Asia, Africa, the Middle East, Eastern Europe, and Latin America. Generally, the letter gets issued within two working days. The letter issued by Citibank covers the financial risk to the importers residing in place or in case of economically weakened situations.
Some of the banks that help in issue the credit letters are:
- ICICI Bank
- Axis Bank
- State Bank of India (SBI)
- HDFC Bank
- Union Bank of India
- Kotak Mahindra Bank
- IDBI Bank
- Bandhan Bank
- Punjab and Sind Bank
- Developmental Bank of Singapore (DBS)
Letter of Credit and Bank Guarantee
Meaning of Bank Guarantee (BG)
A Bank guarantee is a financial mechanism that is issued by the banks and Non-Banking Financial Corporations (NBFCs) to meet the requirements of the customer. In case, the customer is unable to pay or fulfill the requirements as per the agreement, the bank authorities step in to pay as per the agreed demands of the letter.
The money credits issued under bank guarantees work well within business enterprises. It helps in running operations such as sale and purchase of goods as in raw materials, manufacturing machinery, equipment, and improving services.
Difference Between BG and LC
A letter of credit is an assured payment that the trader’s bank gives to the seller after the presentation of the valid documentation. It is a confirmed payment avenue given to the seller in spite of any discrepancy in providing the goods and services.
A Bank guarantee is the guaranteed payment given to a third party as authorized on behalf of the customer. It is a way of assisting the financial needs of the customer to successfully run the business operations.
A Bank guarantee is initiating the required payment to the beneficiary even after not fulfilling the agreement. The letter of credit provides the said credit after fulfilling the agreement terms with the beneficiary.
How to Apply for Letter of Credit
Letter of credit is varied across different types of work, within industries, and marketplaces in countries. A letter of credit gets issued by the buyer’s bank by agreeing upon certain terms and conditions of trading with both parties. All the requisite documents highlighting the details of the buyer and business should be presented for approval of the letter of credit.
Following is the procedure to apply for the letter of credit in international trading scenarios:
- The importer, authorizing bank, and exporter should agree to all the conditions of the sales agreement to make transactions easier.
- The bank initiates drafting the letter of credit after the sales agreement terms and conditions are agreed upon by the importer, exporter, and the bank. The finalized letter is then sent to the bank authorities of the exporter and its reviewing bank.
- When the draft gets approved by the exporter’s bank, the business operations with respect to the shipment of goods and services proceed as mentioned in the outline of the letter of credit.
- All the necessary documents are submitted to its reviewing bank which are then thoroughly checked and should align with the terms and conditions mentioned in the letter of credit.
- All the submitted documents after a thorough evaluation are then submitted back to the importer’s bank.
- When all the documentation with the signed contract and the letter of credit agreed upon by both parties is submitted to the importer bank, the transfer of funds is initiated to the exporter bank as per the letter of credit.
- This approved financial assistance helps the importers receive the shipment of goods for a smooth flow of import-export business trading.
Precautions Considered for Letter of Credit
Some of the precautions that need to be taken for the letter of credit:
- The business owner or the buyer should be a regular banker with a verified beneficiary.
- The letter of credit issued for overseas trading should be confirmed and preferably from an Indian Bank.
- The freight of the goods as decided in the terms and conditions should be checked whether it is pre-paid or included.
- The bank charges need to be paid individually by both the buyer and the seller in their respective countries. In this case, the buyer is required to open the beneficiary’s account in its bank.
- All the expenses in the business operations need to be mentioned in the applicant’s and beneficiary’s accounts.
Benefits and Limitations of a Letter of Credit
There are various advantages and disadvantages concerning the letter of credit such as:
Benefits:
- It acts as a payment reassurance to the seller as confirmed from the buyer’s end by default.
- It is a medium of building trust and dependability between two parties for business within domestic and international sectors.
- It is an official and customized form of document that can be outlined to specific terms and conditions.
- The letter is a well-drafted frame of financial credit and timelines set for both the business parties to operate.
- It helps in smooth fund transfers easing out complex international transactions.
Limitations:
- It has a limitation of paying a certain amount of fee which limits the business choices.
- The approval of the letter of credit can sometimes take more than the stipulated time from both the importer and exporter sides.
- It does not qualify on parameters such as quality of goods and delivery time-frame.
- It doesn’t fit under certain criteria such as unstable exchange rates, supply-chain imbalance, or political instability.
Usage of Letter of Credit in case of Fraud
The letter of credit document is sometimes a part of fraudulent activities such as investment schemes, false documentation, or non-shipments of goods as presented as being done.
In such cases, a letter of undertaking (LOU) that acts as a provisional financial guarantee by the bank is allowed to the client. This LOU helps in raising short-term credit from any foreign branch of some other bank. The foreign bank requires a marginal fee to be paid for the LOU and a credit limit will be approved.
To avoid fraud, it is important that the bank conducts a through due diligence of the traders especially in case of new trading partners.
Conclusion
Letter of credit acts as financial collateral which is a very valuable asset in banking, startups, and business. It acts as the strongest back-up in the running of business given by the bank authorities to its client or the buyer which serves as a financial security to the seller. There are various types of letters of credit issued by various banks, depending on suitability. It is favorable for its creditworthiness, money circulation, and timelines as per the agreed particulars; in the contract by both parties. LC helps you create a good impact as well as a strong foothold in domestic and international markets.