A look at what a letter of credit does and why it poses greater credit risk than the traditional forms of lending

1. Where the Credit Risk Lies
in Letters of Credit
from
businessbankingcoach.com
in association with

2. What are
“letters of
credit”?
And where is the
credit risk?

3. A letter of credit
is a bank product
that solves a
problem for two
parties to an
import/export
transaction

4. I want to export my
goods to my
customer …….but I
don’t want to lose
control of them until
I’m paid
The exporter’s
problem

5. I want to import
goods from my
supplier but I don’t
want to pay until I
have them
The importer’s
problem

6. To resolve the problem
the importer can apply
to his or her bank for
an import letter of
credit……….
……which is really just a
type of guarantee
issued by the bank to
the exporter

7. But how does that help? The
goods still have to be paid for
and they can’t be shipped until
payment is made…..
….can they?

8. Okay, so here’s how it works……

9. The importer instructs the bank to issue an
import letter of credit on his or her behalf
in favour of the exporter…….

10. ….but, importantly, the importer gives the bank a
list of the documents that he or she wants to see
before payment will be made to the exporter under
the import letter of credit.
These documents will assure the importer
that the goods shipped are exactly
what has been ordered.

11. In that list of documents there would
always be something to
confirm that the goods have
been placed on some form of transport
(a ship, a plane, a truck etc.) to prove
that they are on the
way to the importer.

12. Other documents might include;
An invoice issued to the importer describing the
goods and the amount of the transaction
An insurance certificate (depending on who is
responsible for insuring the goods while in
transit)
An independent certification of inspection
And anything else that the importer specifies

13. The bank prepares the letter of credit and
sends it to the exporter’s bank (or an agent
bank in the exporter’s country) who will then
advise the exporter that it has been issued.
The letter of credit will have an expiry date
and will include a date by which the goods
have to be shipped from the exporter’s
country.

14. The exporter then decides whether he or
she can meet the documentation
requirements of the letter of credit as well
as the deadlines for
shipping the goods and
submitting the required
documents to the bank.

15. Once the goods are shipped and the correct
documents submitted to the bank……the
exporter gets paid (usually) and the
documents are then sent to the
importer via his or her bank.

16. There are two important points to note here;
The bank issuing the letter of credit
has no interest in the goods
themselves – only the documents
and…..

17. A letter of credit is always
irrevocable so once the correct
documents are submitted by the
exporter to the local agent bank
and the letter of credit is still
valid, the bank has to pay

18. Okay, that’s all
well and good
but where’s the
credit risk?

19. That last bit about the letter of credit being
irrevocable? That’s the problem for the
bank.
When the correct documents are submitted
by the exporter and the letter of credit has
not expired, the bank has to pay
and, at that point, the importer’s
bank account is debited with
the amount paid to
the exporter.

20. The credit risk, of course, is that there
are no funds in the importer’s bank
account at the time to meet the
payment or, much worse, that the
importer has gone out of business
since the letter of credit was issued.

21. That means that the bank can’t withdraw
the letter of credit, it can only expire if the
bank is to avoid its liability.
The really big problem for the bank is that
the letter of credit has no “get-out” clause
as a normal guarantee usually does –
that’s what makes it irrevocable.

22. So how does the
bank mitigate
the credit risk?

23. The normal credit risk
assessment approach applies
just as though the bank is
providing an overdraft or
loan because that might be
what results when the letter
of credit is paid.

24. But, because of the irrevocable nature of the
letter of credit, it would be normal to seek
collateral unless the letter of credit is being
issued on behalf of a very strong client with a
solid track record and financial position.

25. If the client has available
funds in the bank account at
the time the letter of credit
is issued, the best form of
collateral would be to take
the cash and hold it on a
separate account until
payment or expiry of the
letter of credit (whichever
comes first).

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