A letter of credit is a promise to pay. Banks issue letters of credit as a way to ensure sellers (and sometimes even buyers) that they will get paid as long as they do what they've agreed to do.
Letters of credit are common in international trade, but they are also used in domestic transactions. Either way, a bank acts as an uninterested party between buyer and seller and guarantees that a payment will be made if certain conditions are met.
The concept of a letter of credit can be complicated. The easiest way to get a handle on things is to see an example with visuals.
Importers and exporters regularly use letters of credit to protect themselves. Working with an overseas buyer can be risky because you don't necessarily know who you're working with. Your buyer may be honest and have good intentions, but business troubles or political unrest can delay your payment (or put your buyer out of business). In addition, communication can be difficult across thousands of miles and different time zones. A letter of credit spells out the details so that everybody's on the same page.
Letter of Credit Lingo
To better understand letters of credit, it may help to know the following:
- Abbreviations for 'letter of credit' include L/C, LC, and LOC
- Applicant - the buyer in a transaction
- Beneficiary - the seller or ultimate recipient of funds
- Issuing bank - the bank that promises to pay
- Advising bank - helps the beneficiary use the letter of credit
- Irrevocable - the letter of credit cannot be changed or cancelled without permission from everybody involved
The Money Behind a Letter of Credit
A bank promises to pay on behalf of a customer, but where does the money come from?
The bank will only issue a letter of credit if the bank is confident that the buyer will pay. Some buyers have to deposit enough money to cover the letter of credit, and some customers use a line of credit with the bank (in other words, a loan is created when the payment is made).
Sellers must trust that the bank issuing the letter of credit is legitimate, and that the bank will pay as agreed. If sellers have any doubts, they can use a "confirmed" letter of credit, which means that another (presumably more trustworthy) bank will guarantee payment. Sellers typically get letters of credit confirmed by banks in their home country.
Executing a Letter of Credit
A beneficiary only gets paid after performing specific actions and meeting the requirements spelled out in a letter of credit.
For international trade, the seller may have to deliver merchandise to a shipyard in order to satisfy requirements for the letter of credit. Once the merchandise is delivered, the seller receives documentation proving that he made delivery. The letter of credit now must be paid – even (depending on how things are set up) if something happens to the merchandise. If a crane falls on the merchandise or the ship sinks, it's not necessarily the seller's problem.
To pay on a letter of credit, banks simply review documents proving that a seller performed his required actions. They do not worry about the quality of goods or other items that may be important to the buyer and seller. That doesn't necessarily mean that sellers can send a shipment of junk; sometimes an inspection certificate is required by the letter of credit, so the buyer can be sure that the shipment is acceptable.
For a domestic transaction, a beneficiary might have to prove that somebody failed to do something. For example, an organization might hire a contractor to complete a building project. If the project is not completed on time (and a standby letter of credit is used), the organization can show the bank that the contractor did not meet his obligations. As a result, the bank will pay the organization (so the organization can be compensated, or hire somebody else to complete the project).
Pitfalls of Letters of Credit
Letters of credit make it possible to do business worldwide. They are important and helpful tools, but you should be careful when using letters of credit.
As a seller, make sure you:
- Carefully review all requirements for the letter of credit before moving forward with a deal
- Understand all the documents required
- Are truly able to get all the documents required for the letter of credit
- Understand the time limits associated with the letter of credit, and whether they are reasonable
- Know how quickly your service providers (shippers, etc) will produce documents for you
- Can get the documents to the bank on time
- Make all documents required by the letter of credit match the letter of credit application exactly (even typographical errors or common substitutions can cause problems)
Getting a Letter of Credit
To get a letter of credit, contact your bank. You'll most likely need to work with an international trade department or commercial division. Not every institution works with letters of credit, but small banks and credit unions can often refer you to somebody who is able to accommodate your needs.