In this article we will discuss about:- 1. Meaning of Letter of Credit (LC) 2. Parties Involved in the Letter of Credit (LC) 3. Types 4. Amendment of the Terms 5. Documents 6. Assessment of Exposure 7. Quantitative Assessment.
Meaning of Letter of Credit (LC):
Letter of credit is a letter issued by a bank at the instance of its customer favouring the supplier of goods, whereby the issuing bank undertakes to make payment on submission of certain documents, as specified in the letter. Letters of credit issued by banks facilitate trade between two parties, both at domestic and international levels. Commercial banks play an important role as an intermediary between two trading parties situated in two distant places.
For example, assume that the buyer of certain merchandise is in Mumbai, India, and the seller of the said merchandise is in the USA. The buyer and the seller do not know each other and, therefore, the seller will ask for the payment in advance for shipping the merchandise to the buyer. On the other hand, the buyer feels that it may not be prudent for him to make advance payment to the overseas seller whom he does not know.
Under this circumstance, no trade can take place unless there is an intermediary who can bridge the lack of trust between the buyer and the seller. The commercial bank can play the role of this intermediary and inspire confidence among the two parties. This can be done by issuing an LC at the instance of the buyer in favour of the seller.
The issuing bank undertakes to pay the amount of shipment to the seller, provided the latter submits the shipping and other documents of title as stipulated in the LC through the bank of the seller. This kind of letter of credit is also known as Documentary Credit. When an LC is issued on account of international trade, the buyer is known as the importer of goods and the seller is called the exporter of goods.
Commercial banks all over the world issue letters of credit and the modalities for issuing documentary credits are subject to the provisions of Uniform Customs and Practices for Documentary Credits (UCPDC) framed by the International Chamber of Commerce (ICC). Provisions of UCPDC are common in all countries, and all commercial banks handle LC business as per the guidelines of UCPDC.
It is important to bear in mind that under letters of credit, commercial banks deal with documents and not the underlying goods. If the documents are strictly in compliance, with the terms of LC, the issuing bank has to make payment to the seller’s bank, irrespective of the condition of the goods.
In an international LC transaction many parties are involved and they are spread over different countries. They function under different legal systems and jurisdictions. Settlement of any dispute, arising out of any terms and conditions of the LC, through normal legal channels, may pose difficulties.
It was against this backdrop that codification and publication of a common set of rules, applicable to all documentary credits irrespective of which bank has issued it, were framed at the behest of the ICC. The document, known as the UCPDC, is revised from time to time. In order to ensure that the rules of UCPDC apply to a documentary credit, it is necessary to declare on the body of the LC that it is being issued subject to the provisions of UCPDC.
Parties Involved in the Letter of Credit (LC):
A letter of credit transaction involves the following parties:
The buyer finalises the terms and conditions of a purchase transaction and submits a request in the prescribed format to his bank for issuing a letter of credit in favour of the seller. The applicant is also called the ‘opener’ of the credit.
The beneficiary of the letter of credit is the person in whose favour the LC has been issued. Generally, the LC is issued favouring the seller of the goods and services.
3. Opening/Issuing Bank:
On receipt of the application from its customer, the bank examines the proposal and opens a letter of credit in favour of the beneficiary with the stipulated terms and conditions. This bank is known as the opening/issuing bank.
4. Advising Bank:
The opening bank identifies a bank near the place of the beneficiary or the seller, and advises the LC to the seller through that bank. This bank is known as the advising bank. The issuing bank may have its own branch at the place where the beneficiary is located or may arrange with a correspondent bank operating at that place in order to render advisory and authentication services.
5. Confirming Bank:
Though the advising bank may advise the authenticity of the credit to the beneficiary, the latter may desire to have the comfort of an additional confirmation from a bank in his own place, which provides its own independent undertaking for making payment, provided the documents are submitted strictly in terms of the LC.
The beneficiary normally stipulates for additional confirmation, if he feels that there is a risk of default by the issuing bank in making payment under the LC. If the issuing bank is a relatively small financial institution, the beneficiary generally asks for confirmation by another bank in his own country.
6. Negotiating Bank:
The issuing bank may nominate another bank in the beneficiary’s country to whom the beneficiary presents its documents and obtains payment of the sum against the LC. This bank is known as the negotiating bank. The role of the negotiating bank may be played by the issuing bank, the advising bank or any other bank, depending on the terms of the documentary credit. In a freely negotiable credit, any bank can act as the negotiating bank.
7. Reimbursing Bank:
The issuing bank of the LC may arrange with another bank to reimburse the amount under the LC to the negotiating bank that has made payment to the beneficiary. Such banks are known as reimbursing banks.
Types of Letters of Credit:
There are various types of LCs, depending on the method of payment and other conditionalities envisaged under the credit.
The various types of LCs are, normally, as under:
1. Revocable and Irrevocable Letter of Credit:
Generally, a letter of credit is deemed to be irrevocable and cannot be amended or cancelled without an express agreement of all the parties concerned, i.e., the applicant, the issuing bank, the confirming bank, if any, and the beneficiary. On the other hand, a revocable credit issued by a bank may be amended or cancelled by the issuing bank at any point of time, without giving any notice to the beneficiary.
In these cases, however, the issuing bank has to reimburse the other bank which has either paid or has accepted a liability to pay any amount in accordance with the terms and conditions of the credit, before receipt of a notice of amendment or cancellation of the credit by the issuing bank.
2. Sight Credit and Acceptance (Usance) Credit:
Under sight credits, the issuing bank undertakes to pay the amount mentioned in the documents, on presentation thereof, provided the documents are strictly in compliance with the terms of the LC. On receipt of the documents, the opening bank informs the applicant (customer) to make the payment and collect the shipping documents (bill of lading, airway bill, railway receipt, etc.) to take delivery of the merchandise from the place of their arrival.
On the other hand, in case of usuance LC, an element of supplier’s credit is involved, which means that the seller is agreeable to extend credit to the buyer and accept payment after expiry of a certain period mentioned in the documents submitted under the LC. Upon receipt of the documents, the opening or issuing bank presents the documents to the buyer (customer) who notifies acceptance of the documents and commits to pay the amount on the due date.