A complete and excellent slide on Letter of Credit

1. Letter Of CreditLetter Of Credit

2. DefinitionDefinition
 A document issued by a financial institutionA document issued by a financial institution
on behalf of a buyer stating the amount ofon behalf of a buyer stating the amount of
credit the buyer has available, and that thecredit the buyer has available, and that the
institution will honor drafts up to that amountinstitution will honor drafts up to that amount
written by the buyer. It gives the buyer thewritten by the buyer. It gives the buyer the
prestige and financial backing of the issuingprestige and financial backing of the issuing
institution and satisfies the requirements ofinstitution and satisfies the requirements of
the seller in completing the transaction. Thethe seller in completing the transaction. The
accepting institution has a prior agreement asaccepting institution has a prior agreement as
to how the buyer will pay for the drafts asto how the buyer will pay for the drafts as
they are presented.they are presented.
 A commitment, usually by a bank on behalf ofA commitment, usually by a bank on behalf of
a client, to pay a beneficiary a stated amounta client, to pay a beneficiary a stated amount
of money under specified conditions.of money under specified conditions.

3. Parties involved in LC transactionParties involved in LC transaction
 TheThe ApplicantApplicant is the party that arranges foris the party that arranges for
the letter of credit to be issued.the letter of credit to be issued.
 TheThe BeneficiaryBeneficiary is the party named in theis the party named in the
letter of credit in whose favor the letter ofletter of credit in whose favor the letter of
credit is issued.credit is issued.
 TheThe Issuing or Opening BankIssuing or Opening Bank is theis the
applicant’s bank that issues or opens theapplicant’s bank that issues or opens the
letter of credit in favor of the beneficiary andletter of credit in favor of the beneficiary and
substitutes its creditworthiness for that of thesubstitutes its creditworthiness for that of the
applicant.applicant.

4. Parties involved in LC transaction (Contd..)Parties involved in LC transaction (Contd..)
 AnAn Advising BankAdvising Bank may be named in the letter ofmay be named in the letter of
credit to advise the beneficiary that the letter ofcredit to advise the beneficiary that the letter of
credit was issued. The role of the Advising Bank iscredit was issued. The role of the Advising Bank is
limited to establish apparent authenticity of thelimited to establish apparent authenticity of the
credit, which it advises.credit, which it advises.
 TheThe Paying BankPaying Bank is the bank nominated in theis the bank nominated in the
letter of credit that makes payment to theletter of credit that makes payment to the
beneficiary, after determining that documentsbeneficiary, after determining that documents
conform, and upon receipt of funds from the issuingconform, and upon receipt of funds from the issuing
bank or another intermediary bank nominated by thebank or another intermediary bank nominated by the
issuing bank.issuing bank.
 TheThe Confirming BankConfirming Bank is the bank, which, underis the bank, which, under
instruction from the issuing bank, substitutes itsinstruction from the issuing bank, substitutes its
creditworthiness for that of the issuing bank. Itcreditworthiness for that of the issuing bank. It
ultimately assumes the issuing bank’s commitment toultimately assumes the issuing bank’s commitment to
pay.pay.

5. Letter of Credit ProcessLetter of Credit Process

6. Commercial Letter of Credit FlowCommercial Letter of Credit Flow
1.1. Applicant approaches Issuing/ Opening Bank withApplicant approaches Issuing/ Opening Bank with
LC application form duly filled and requests IssuingLC application form duly filled and requests Issuing
Bank to issue a Letter of Credit in favour ofBank to issue a Letter of Credit in favour of
Beneficiary.Beneficiary.
2.2. Issuing Bank issues a Letter of Credit as per theIssuing Bank issues a Letter of Credit as per the
application submitted by an Applicant and sends itapplication submitted by an Applicant and sends it
to the Advising Bank, which is located into the Advising Bank, which is located in
Beneficiary’s country, to formally advise the LC toBeneficiary’s country, to formally advise the LC to
the beneficiary.the beneficiary.
3.3. Advising Bank advises the LC to the Beneficiary.Advising Bank advises the LC to the Beneficiary.
4.4. Once Beneficiary receives the LC and if it suits his/Once Beneficiary receives the LC and if it suits his/
her requirements, he/ she prepares the goods andher requirements, he/ she prepares the goods and
hands over them to the carrier for dispatching tohands over them to the carrier for dispatching to
the Applicant.the Applicant.
5.5. He/ She then hands over the documents along withHe/ She then hands over the documents along with
the Transport Document as per LC to thethe Transport Document as per LC to the
Negotiating Bank to be forwarded to the IssuingNegotiating Bank to be forwarded to the Issuing
Bank.Bank.

7. Commercial Letter of Credit FlowCommercial Letter of Credit Flow
(Contd..)(Contd..)
6. Issuing Bank reimburses the Negotiating Bank with6. Issuing Bank reimburses the Negotiating Bank with
the amount of the LC post Negotiating Bank’sthe amount of the LC post Negotiating Bank’s
confirmation that they have negotiated theconfirmation that they have negotiated the
documents in strict conformity of the LC terms.documents in strict conformity of the LC terms.
Negotiating Bank makes the payment to theNegotiating Bank makes the payment to the
Beneficiary.Beneficiary.
7. Simultaneously, the Negotiating Bank forwards the7. Simultaneously, the Negotiating Bank forwards the
documents to the Issuing Bank to be released to thedocuments to the Issuing Bank to be released to the
Applicant to claim the goods from the carrier.Applicant to claim the goods from the carrier.
8. Applicant reimburses the Issuing Bank for the8. Applicant reimburses the Issuing Bank for the
amount, which it had paid to the Negotiating Bank.amount, which it had paid to the Negotiating Bank.
9. Issuing Bank releases all documents along with the9. Issuing Bank releases all documents along with the
titled Transport Documents to the Applicant.titled Transport Documents to the Applicant.

8. Types of Letters of CreditTypes of Letters of Credit
 RevocableRevocable
 IrrevocableIrrevocable
 UnconfirmedUnconfirmed
 ConfirmedConfirmed
 TransferableTransferable
 Assignment of ProceedsAssignment of Proceeds
 RevolvingRevolving
 StandbyStandby

9. Settlements Under a Letter ofSettlements Under a Letter of
CreditCredit
 All commercial letters of credit mustAll commercial letters of credit must
clearly indicate whether they areclearly indicate whether they are
payable by sight payment, by deferredpayable by sight payment, by deferred
payment, by acceptance, or bypayment, by acceptance, or by
negotiation. These are noted as formalnegotiation. These are noted as formal
demands under the terms of thedemands under the terms of the
commercial letter of credit.commercial letter of credit.

10. Settlements Under a Letter of Credit (Contd..)Settlements Under a Letter of Credit (Contd..)
 In aIn a sight paymentsight payment, the commercial letter, the commercial letter
of credit is payable when the beneficiaryof credit is payable when the beneficiary
presents the complying documents and if thepresents the complying documents and if the
presentation takes place on or before thepresentation takes place on or before the
expiration of the commercial letter of credit.expiration of the commercial letter of credit.
 In aIn a deferred paymentdeferred payment, the commercial, the commercial
letter of credit is payable on a specified futureletter of credit is payable on a specified future
date. The beneficiary may present thedate. The beneficiary may present the
complying documents at an earlier date, butcomplying documents at an earlier date, but
the commercial letter of credit is payable onlythe commercial letter of credit is payable only
on the specified future date.on the specified future date.

11. Settlements Under a Letter of CreditSettlements Under a Letter of Credit
(Contd..)(Contd..)
 AnAn acceptanceacceptance is a time draft drawn on, andis a time draft drawn on, and
accepted by, a banking institution, which promises toaccepted by, a banking institution, which promises to
honor the draft at a specified future date. The act ofhonor the draft at a specified future date. The act of
acceptance is without recourse as it is a commitmentacceptance is without recourse as it is a commitment
to pay the face amount of the accepted draft.to pay the face amount of the accepted draft.
 Under negotiation, theUnder negotiation, the negotiating banknegotiating bank, a third, a third
party negotiator, expedites payment to theparty negotiator, expedites payment to the
beneficiary upon the beneficiary’s presentation of thebeneficiary upon the beneficiary’s presentation of the
complying documents to the negotiating bank. Thecomplying documents to the negotiating bank. The
bank pays the beneficiary, normally at a discount ofbank pays the beneficiary, normally at a discount of
the face amount of the value of the documents, andthe face amount of the value of the documents, and
then presents the complying documents, including athen presents the complying documents, including a
sight or time draft, to the issuing bank to receive fullsight or time draft, to the issuing bank to receive full
payment at sight or at a specified future date.payment at sight or at a specified future date.

12. Advantages of Letter of CreditAdvantages of Letter of Credit
1.1. The beneficiary is assured of payment asThe beneficiary is assured of payment as
long as it complies with the terms andlong as it complies with the terms and
conditions of the letter of credit.conditions of the letter of credit.
2.2. The credit risk is transferred from theThe credit risk is transferred from the
applicant to the issuing bank.applicant to the issuing bank.
3. The beneficiary minimizes collection time as3. The beneficiary minimizes collection time as
the letter of credit accelerates payment ofthe letter of credit accelerates payment of
the receivables.the receivables.
4. The beneficiary’s foreign exchange risk is4. The beneficiary’s foreign exchange risk is
eliminated with a letter of credit issued ineliminated with a letter of credit issued in
the currency of the beneficiary’s country.the currency of the beneficiary’s country.

13. Risks involvedRisks involved
1. Since all the parties involved in Letter of Credit deal1. Since all the parties involved in Letter of Credit deal
with the documents and not with the goods, the riskwith the documents and not with the goods, the risk
of Beneficiary not shipping goods as mentioned inof Beneficiary not shipping goods as mentioned in
the LC is still persists.the LC is still persists.
2. The Letter of Credit as a payment method is costlier2. The Letter of Credit as a payment method is costlier
than other methods of payment such as Openthan other methods of payment such as Open
Account or CollectionAccount or Collection
3. The Beneficiary’s documents must comply with the3. The Beneficiary’s documents must comply with the
terms and conditions of the Letter of Credit forterms and conditions of the Letter of Credit for
Issuing Bank to make the payment.Issuing Bank to make the payment.
4. The Beneficiary is exposed to the Commercial risk on4. The Beneficiary is exposed to the Commercial risk on
Issuing Bank, Political risk on the Issuing Bank’sIssuing Bank, Political risk on the Issuing Bank’s
country and Foreign Exchange Risk in case of Usancecountry and Foreign Exchange Risk in case of Usance
Letter of Credits.Letter of Credits.

14. ReferenceReference
 (http://www.teachmefinance.com/Financial_Terms/le(http://www.teachmefinance.com/Financial_Terms/le
tter_of_credit.html)tter_of_credit.html)
 http://en.wikiversity.org/wiki/Letters_of_Credit/Resouhttp://en.wikiversity.org/wiki/Letters_of_Credit/Resou
rcesrces..
 International Trade:Financial Services for ImportersInternational Trade:Financial Services for Importers
and Exporters, JP Morgan/Chase Bank, 2000.and Exporters, JP Morgan/Chase Bank, 2000.
 Financial management By Prasanna chandraFinancial management By Prasanna chandra
 International financial management By VK.BhallaInternational financial management By VK.Bhalla
 Fundamentals of corporate finance By RossFundamentals of corporate finance By Ross
Westerfield JordanWesterfield Jordan

15. ReferenceReference
 (http://www.teachmefinance.com/Financial_Terms/le(http://www.teachmefinance.com/Financial_Terms/le
tter_of_credit.html)tter_of_credit.html)
 http://en.wikiversity.org/wiki/Letters_of_Credit/Resouhttp://en.wikiversity.org/wiki/Letters_of_Credit/Resou
rcesrces..
 International Trade:Financial Services for ImportersInternational Trade:Financial Services for Importers
and Exporters, JP Morgan/Chase Bank, 2000.and Exporters, JP Morgan/Chase Bank, 2000.
 Financial management By Prasanna chandraFinancial management By Prasanna chandra
 International financial management By VK.BhallaInternational financial management By VK.Bhalla
 Fundamentals of corporate finance By RossFundamentals of corporate finance By Ross
Westerfield JordanWesterfield Jordan