Meaning of Letter of Credit, Steps of L/C transactions and advantages and disadvantaged of Letter of Credit

Meaning

Letter of credit is the written instrument issued by the importer’s (buyer’s) bank to the exporters (seller).  L/C is the guarantee given by buyer’s banks to remit the amount to the seller according to the terms and conditions based on the contractual agreement between buyer and seller.  L/C is the most reliable and acceptable method of obtaining the payment for exporter.

There are seven parties which are normally associated with the letter of credit. These parties are:

Sr. No. Parties Details
1 Applicant The importer, who apply to his bank for letter of
credit.
2 Opening Bank The bank, which issues the letter of credit in
response to the request of the importer. This bank is also known as issuing
bank.
1 Beneficiary Bank The bank of exporter or the seller in favor of
whom the LC is open.
4 Advising Bank The bank that is intimating credit to the
beneficiary.
5 Confirming Bank The bank in beneficiary’s country which
guarantees the credit on the request of the beneficiary.
6 Negotiating Bank The bank to whom the draft and other documents
are presented by the exporters. This bank negotiates the documents under L/C
and credits the accounts of the beneficiary.
7 Beneficiary The exporter, who get the payment.

Steps of L/C transactions

The following is the step by step description of a typical L/C transaction:

1.       The importer and exporter agree to enter into purchase and sales transaction where payment is made by Letter of Credit.

2.       The importer approaches to the bank (Known as issuing bank) to issue a letter of credit in favor of exporter.

3.       The issuing bank, issue a letter of credit and send it advising bank according to instructions of the importer. The advising bank is located in the country where exporter carry the business or it may be exporter’s bank.

4.       The advising bank will verify the Letter of Credit for authenticity and send a copy to the exporter.

5.      The exporter examines the letter of credit to ensure that L/C is as per the terms and conditions decided between him and importer. It is also necessary for exporter to confirm that documents stipulated in the L/C can be produced by him and conditions given will be fulfilled.

6.       If exporter found that terms and conditions mentioned in L/C are not as per the purchase/sales agreement, then exporter should immediately notify the importer and request him to make amendments in the letter of credit.

7.        When exporter gets L/C (Or amended L/C if required) then exporter arranges for shipment of goods and also obtained the documents stipulated in the L/C.

8.       Exporter makes demand under L/C by presenting the documents before expiry; to his bank. The banks check the documents according to the Letter of Credit and forward the same to the issuing bank.

9.       Issuing bank examine the documents to ensure they comply with the letter of credit terms and conditions.

10.   Documents delivery to the importer to allow them to take possession of the goods from port. The transaction is complete importer has received the goods and exporter has obtained the payment.

Important point I would like to mention here is that banks only deal in documents. Decision to pay under L/C is entirely on the basis of documents presented to the bank and according to the terms and conditions of the letter of credit.

Advantages and disadvantages of using letter of credit

Advantage to Importer

1.       Importer is ensured that exporter will be paid only when all terms and conditions of the L/C satisfy.

2.       Importer is in a position to negotiate more favorable trade terms with the exporter as L/C facilitates payment surety to the exporter.

Advantage to Importer

1.       Risk of payment is eliminated. Exporters need not required to verify the creditworthiness of the importer when payment method is letter of credit.

2.       Exporter knows and agrees all the terms and conditions of the trade in advance. If letter of credit is not issued as agreed, the exporter is not obligated to ship the goods.

Disadvantage to importer

1.       A letter of credit does not offer protection to the importer against the exporter for shipping the inferior quality of goods. (There is a solution for this disadvantage. The importer can ask the certificate of inspection/quality as additional documents requirement in the Letter Of Credit.)

2.       It is necessary for the importer to have line of credit with a bank then only bank can issue L/C.

Disadvantage to exporter

1.       Documents must be prepared and presented in strict compliance with the requirements stipulated in the Letter of Credit.

2.       Some importer may not be able to issue Letter of Credit due to the lack of credit facilities with their bank. It is difficult to get the L/C from importer for export of perishable goods.

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