A Letter of Credit is issued by a bank at the request of its customer (importer) in favour of the beneficiary (exporter). It is an undertaking/ commitment by the bank, advising/informing the beneficiary that the documents under a LC would be honoured, if the beneficiary (exporter) submits all the required documents as per the terms and conditions of the LC.
Importance of letter of credit in trade activities
The trade can be classified into Inland and International. Due to the geographical proximities of the importers and the exporters, banks are involved in LC transactions to avoid default in payment (credit risks). To facilitate trade and also to enable the exporter and importer to receive and pay for the goods sold and bought, letter of credit is used as a tool. Letter of credit mechanism that the payment and receipts (across the globe) are carried out in an effective manner
Letter of Credit Parties
1. Applicant (importer) requests the bank to issue the LC
2. Issuing bank (importer’s bank which issues the LC [also known as Opening banker of LC])
3. Beneficiary (exporter) Different types of banks:
- Opening bank (a bank which issues the LC at the request of its customer [importer])
- Advising bank (the issuing banker’s correspondent who advices the LC to beneficiary’s banker and/ or beneficiary)
- Negotiating bank (the exporter’s bank, which handles the documents submitted by the exporter. The bank also finances the exporter against the documents submitted under a LC)
- Confirming bank (the bank that confirms the credit)
- Reimbursing bank (reimburses the LC amount to the negotiating/ confirming bank)
Types of Letter of Credit (LC)
- (a) Sight Credit – Under this LC, documents are payable at sight/ upon presentation
- (b) Acceptance Credit/ Time Credit – The Bills of Exchange which are drawn, payable after a period, are called usance bills. Under acceptance credit usance bills are accepted upon presentation and eventually honoured on due dates.
- (c) Revocable and Irrevocable Credit – A revocable LC is a credit, the terms and conditions of the credit can be amended/ cancelled by the Issuing bank, without prior notice to the beneficiaries. An irrevocable credit is a credit, the terms and conditions of which can neither be amended nor cancelled without the consent of the beneficiary. Hence, the opening bank is bound by the commitments given in the LC.
- (d) Confirmed Credit – Only Irrevocable LC can be confirmed. A confirmed LC is one when a banker other than the Issuing bank, adds its own confirmation to the credit. In case of confirmed LCs, the beneficiary’s bank would submit the documents to the confirming banker.
- (e) Back-to-Back credit – In a back to back credit, the exporter (the beneficiary) requests his banker to issue a LC in favour of his supplier to procure raw materials, goods on the basis of the export LC received by him. This type of LC is known as Back-to-Back credit. Example: An Indian exporter receives an export LC from his overseas client in Netherlands. The Indian exporter approaches his banker with a request to issue a LC in favour of his local supplier of raw materials. The bank issues a LC backed by the export LC.
- (f) Transferable Credit – While a LC is not a negotiable instrument, the Bills of Exchange drawn under it are negotiable. A Transferable Credit is one in which a beneficiary can transfer his rights to third parties. Such LC should clearly indicate that it is a ‘Transferable’ LC
- (g) “Red Clause” Credit & “Green Clause” Credit – In a LC a special clause allows the beneficiary (exporter) to avail of a pre-shipment advance (a type of export finance granted to an exporter, prior to the export of goods). This special clause used to be printed (highlighted in red colour, hence it is called “Red Clause” Credit. The issuing bank undertakes to repay such advances, even if shipment does not take place.
- In case of a ‘Green clause’ credit, the exporter is entitled for an advance for storage (warehouse) facilities of goods. The advance would be granted only when the goods to be shipped have been warehoused, and against an undertaking by the exporter that the transportation documents would be delivered by an agreement date.
- (h) Standby LC: In certain countries there are restrictions to issue guarantees, as a substitute these countries use standby credit. In case the guaranteed service is not provided, the beneficiary can claim under the terms of the standby credit. In case of Standby LCs, the documents required are proof of non-performance or a simple claim form.