Letter of Credit or Documentary Credit is used for Import finance which the importing entities use to reduce risk on their import from unknown exporters of other countries. In cross-country trade, importers pay the money to the exporter only after receiving the goods and services from other countries. They use letter of credit mechanism for the settlement of payment between themselves.
A letter of credit is a document which a financial institution or bank issues to the exporter of the goods in foreign country which provides the guarantee that the issuer will pay him the money for goods once the exporter deliver the same to another importer. The issuer of letter of credit takes the payment from the importer and pays to the exporter once the shipment is completed.
The steps involved in letter of credit mechanism are
Due to high increase in cross border trading and high fees involved in the letter of credit process banks are now trying to provide different letter of credit services to satisfy different customers. Banks are also extending their network to other countries to reduce dependency on other banks while taking this service.
Types of Letter of Credits
There are various types of letters of credit available depending on contract terms associated with the same. These are
Revocable: A revocable Letter of Credit can be cancelled or revoked at any time by the importer without the consent of the exporter. This option is not used as it possesses significant risk to the exporter. By default all the Letter of Credits are irrevocable.
Irrevocable: An irrevocable Letter of Credit can be revoked only after the consent of all the related parties involved in the process. By default, all the letter of credits is irrevocable.
Revolving Credit: Revolving letter of credit is used for repeated import of same type of goods by the same importer over a period of time. In revolving credit, the amount is re-instated and made available to the exporter on periodic basis to enable him export the same goods multiple times to the same importer. It is very useful for importers who want to import the same material from a cross-border exporter at regular intervals for a specified period of time.
Confirmed: A confirmed letter of Credit contains an additional confirmation from some other bank in addition to the issuing bank. The confirming bank takes on an obligation to pay even if the issuing bank defaults and fails oblige the payment obligation.
Standby Credit: Standby credit is a default instrument which protects the exporter from the default of importer or failure of any obligation of the applicant. Here the beneficiary is eligible for payment when the applicant fails to perform the obligation specified in the terms and conditions.
Back-to-Back: The original letter of credit is used as security by the exporter to open another credit in favor of another exporter of its own group. Here the issuing bank may be different, but the original letter of credit is used as security for the later one.
Deferred Payment Credits: In this type of letter of credit option, the payment is deferred for future until the imported material is used properly by the importer. Here payment is made in different installments based on the contracts terms and conditions. Suppose one importer is importing some equipment to build a nuclear reactor from an overseas supplier. The deferred payment schedule can be 20% advance payment, 50% after receiving the equipment and rest 30% after successful completion of the project.
Risks associated with Letter of Credit
Due to its cross border transactions and involvement of not well-known parties leads to multiple risks associated with Letter of Credit process. The main risks are
Due to these risks banks charge very high fee to support letter of credit transactions. Also banks need to have very good risk management mechanism to mitigate these risks arising out of cross border transactions.