Letter of credit

A letter of credit is commercial tool through which a bank or other financial institution instructs a suitable institution to advance a specified sum of money to the bearer. It is primarily used by importers to offer secure financing to exporters. The letter of credit refers to the document representing the goods, not the goods themselves. It is called a circular letter of credit when it is not addressed to any particular corresponding institution. In effect, a letter of credit is a draft indicating a dollar (or other currency) amount as a maximum that is not to be exceeded. Letters of credit greatly simplify nonlocal business transactions. Institutions that issue such letters are generally well-known FINANCIAL INTERMEDIARIES, and any bank will honor the letter upon verification of proper identification. There are several types of letters of credit. A commercial letter of credit is typically written with payment designated to a third party, possibly a creditor financing the transaction between the importer and exporter. A performance letter of credit is issued to guarantee performance under an agreement. A confirmed letter of credit is one that guarantees payment by the issuing bank. A revolving letter of credit is one that is renewed automatically within the time frame and amount limits specified. A traveler’s letter of credit lists banks at which drafts against the letter of credit will be accepted. All letters of credit contain specific elements, including the name of the issuing bank, the buyer’s name, the seller’s name, a specified amount, specific time limits, terms and conditions of documentation, and a specific place to present documents. When all conditions are met, the issuing bank guarantees to pay the seller the specified amount. In effect the bank is substituting its credit for the buyer’s credit, reducing the seller’s risk. Although letters of credit are a common mode of payment, there are many problems associated with them, including the possibility that the seller’s documents will be rejected by the bank at presentation. This can be extremely aggravating to both the importer and exporter and can result in loss of potential customers. Banks act to protect their customers but are usually not concerned whether the CONTRACT between the buyer and seller is performed exactly as per the terms. A bank’s concern is that the documents presented by the seller conform to the documents required under the letter of credit and whether they are presented within the time period required.