letter of credit

What It Is

A letter of credit is a bank's written promise that it will make a customer's (the holder) payment to a vendor (called the beneficiary) if the customer does not.

How It Works

Letters of credit are most common in international transactions, where buyers and sellers may not know each other well or laws and conventions may make certain transactions difficult. For example, let's assume that Company XYZ sells widgets in Alabama and Company ABC manufactures widgets in Lithuania. Company XYZ wants to import $100,000 worth of widgets manufactured by Company ABC, but Company ABC is concerned about XYZ's ability to pay for them.

To address this, Company XYZ gets a letter of credit from its bank, Bank of Alabama, indicating that Company XYZ will make good on the $100,000 payment in, say, 60 days, or Bank of Alabama will pay the bill itself. Bank of Alabama then sends the letter of credit to Company ABC, which then agrees to ship the widgets.

After the shipment goes out, Company ABC (or Company ABC's bank) then asks for its $100,000 by presenting a written draft (also called a bill of exchange) to Bank of Alabama. Although letters of credit mostly benefit sellers, they also protect buyers, because Company ABC must present Bank of Alabama with written proof of the widget shipment in order to get paid. This proof usually includes a commercial invoice, bill of lading, or an airway bill. After Bank of Alabama pays Company ABC, it turns to Company XYZ for reimbursement (usually by debiting Company XYZ's bank account).

Banks usually require a pledge of securities or cash collateral in order to issue a letter of credit to a holder. Banks also collect a fee for issuing letters of credit; the fee is usually a percentage of the size of the letter of credit. The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits governs letters of credit used in international transactions. In the United States, the Uniform Commercial Code governs letters of credit used for domestic transactions.

There are several kinds of letters of credit:

A commercial letter of credit is one of the most common and is reflected in the example above. This kind of letter acts as the primary payment mechanism between the customer and the beneficiary; that is, the issuing bank makes the actual payments to the beneficiary every time. So in our example above, Bank of Alabama pays Company ABC directly, even if Company XYZ has the cash and the means to fulfill its obligation to Company ABC.

A standby letter of credit, on the other hand, is a secondary payment mechanism, meaning that the bank pays the beneficiary only when the holder cannot. Both parties to a standby letter of credit never hope to have to use it. In our example above, Bank of Alabama would only pay Company ABC directly if Company XYZ couldn't.

A revolving letter of credit lets the customer make any number of draws for a certain period as long as they do not exceed a certain limit.

A traveler's letter of credit is a promise that the issuing bank will honor drafts made at certain foreign banks.

A confirmed letter of credit is a letter of credit that has another bank besides the issuing bank standing behind it. This second bank is called the confirming bank, and it is usually (but not always) the seller's bank. The confirming bank ensures payment under the letter of credit if the holder and the issuing bank default on the letter of credit. This is usually done at the request of the issuing bank in international transactions.

Letters of credit are usually negotiable instruments, meaning that the issuing bank must pay the beneficiary or any bank nominated by the beneficiary. In some cases, letters of credit are also transferable, meaning that the beneficiary has the right to assign the right to draw to another entity (such as a corporate parent or even a third party).

Why It Matters

A letter of credit is a tool to reduce risk -- it essentially substitutes the bank's credit for the customer's credit and helps facilitate international trade.

It is important to note that a letter of credit is not the same as a bank guarantee, although with both instruments the issuing bank accepts a customer's liability if the customer defaults. With a guarantee, the seller's claim goes first to the buyer, and if the buyer defaults, then the claim goes to the bank. With letters of credit, the seller's claim goes first to the bank, not the buyer. Although the seller will probably get paid in both cases, letters of credit offer more assurance to sellers than guarantees generally do.

Source: Investing Answers