The credit letter (Letter of Credit), is a kind of business letter issued by the bank for the purpose of providing the guarantee of payment between the buyer and seller on time. The credit letter is a kind of bank guarantee to the seller; that means the bank will cover the full cost of the trade-in case the buyer fails to deposit funds on time.
The term ‘Letter of Credit’ is used when the bank provides a Guarantee Letter on behalf of the businessman (Termed as a ‘Buyer). The guarantee is meant for a person (Termed as a ‘Seller’), who is dealing with the businessman (Buyer) by selling goods from a foreign country. The bank guarantees the seller that the buyer will make the payment. In case the buyer fails, the Bank will pay to the seller. This letter that is providing the guarantee to the seller is called ‘Letter of Credit’.
The Letter of Credit has a very important value in the field of international trade, it provides a facility that caters for factors like:-
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- Distance between the two parties dealing in trade.Different trade laws in different countries.
- Lack of personal rapport between the two parties.
- Eradicating the risk of fraud.
- Ensuring the payment in time
- Ensuring the amount of payment is correct and complete.
- Bank earns a sizeable fee, based on the percentage of the amount involved.
Letter of Credit Terms
Letter of Credit is based on the following rules/system:-
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- It is a document that involves an amount that is often negotiable.
- It is a guarantee, which ensures that the bank will pay the amount to the beneficiary.
- The beneficiary has the facility to nominate another bank or a third party to receive the amount.
- Letter of Credit is a transferable document.
- In case of a transferable Letter of Credit, the beneficiary enjoys the facility of assigning, a third party or a corporate partner to draw the amount.
On what conditions the bank can issue a Credit Letter?
To issue a Letter of Credit, the bank requires the following:-
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- Written Securities on a valid Judicial Paper.
- An equal amount of cash is deposited in the account of the beneficiary that cannot be withdrawn, being a collateral deposit.
- The bank is paid a fee on a percentage basis
- International Chamber of Commerce endorses the letter of credit, based on international laws.
Types of Letters of Credit
There are four types of Letter of Credits that are issued by the banks. These areas are given below:-
#1 Commercial Letter of Credit.
The bank pays the amount to the beneficiary directly.
#2 Revolving Letter of Credit.
It is a facility for the seller; payment can be drawn in a number of parts. However, the total amount involved must be drawn within a specified time.
#3 Letter of Credit for Travellers.
Travelers that are carrying drafts in place of cash require a sort of guarantee letter for the banks in the country. This letter guarantees that the foreign bank will receive the drawn amount.
#4 Confirmed Letter of Credit.
The requirement of international trade. It involves a second bank, in most case the second bank is the one in which the seller has his account. In this system, the second bank is also known as the ‘Confirming Bank’. This bank covers the payment to the seller in case of non-payment by the buyer or his bank.
An Example of issuing a Letter of Credit
International Banks like Citibank are responsible to provide the Letter of Credit in a number of countries, like Latin America, Europe, Asia, Africa, and the Middle East. It is a requirement of buyers who are involved in import and export business, as they have to obtain international credit. The letter issued by Citibank helps them to provide a guarantee for the exporter against any risk.
As and when the seller applies for the issue of a Letter of Credit from the concerned bank, the process takes two working days.
Terms in use in Banks for Credit Letter:
Irrevocable. (ILOC).This is issued on the request of the importer, one who applies for the letter of credit. Once issued it cannot be canceled.
Transferable. This letter is meant for a primary beneficiary who acquires the facility of transferring their credit to the secondary beneficiary.
Synthetic. The payment is pre-funded by the bank; therefore it is a transferable document that provides a guarantee of payment.
Bank Confirmation Letter. (BCL) This confirms to the other banks, that their customer/client has a valid line of credit with them.
Back to Back Letters. The Bank issuing a Letter of Credit issues a second such letter on the request of the seller so that the seller is able to purchase additional equipment or services from another contractor.
Contingent Guarantee. In case of a non-payment by the buyer, a third party is involved as a guarantor for the satisfaction of the seller.