AMITY GLOBAL

BUSINESS SCHOOL Noida

Letter of Credit
Sachin Rohatgi

1
AMITY GLOBAL
BUSINESS SCHOOL Noida

Letter of Credit
• Principles and Theory :

– it is most important segment of non fund based business for banks.

– it is also known as documentary credit.

– a need for a streamlined system involving banks as an intermediate was felt

by the trading world because of the inherent drawbacks of the documentary

collection system prevailing earlier, which poses risk both for importer and

exporter , which led to the evolution of Letter of Credit or Documentary

Credit system.
AMITY GLOBAL
BUSINESS SCHOOL Noida

• Definition:
– A Letter of Credit, simply defined, is a written instrument issued by a bank at the
request of its customer, the Importer (Buyer), whereby the bank promises to pay
the Exporter (Beneficiary) for goods or services, provided that the Exporter
presents all documents called for, exactly as stipulated in the Letter of Credit, and
meet all other terms and conditions set out in the Letter of Credit.
• If the Letter of Credit is issued in course of international trade

– the Letter of Credit should comply with FEMA regulations,

– and are also subject to provisions of Uniform Customs and Practices for
Documentary Credit (UCPDC) framed by International Chamber of Commerce
(ICC)
AMITY GLOBAL
BUSINESS SCHOOL Noida

• Synopsis :

Letter of Credit therefore:

– Are an arrangement by banks for settling international commercial transactions.

– Provide a form of security for the parties involved.

– Ensure payment, provided that the terms and conditions of the Letter of Credit have

been fulfilled.

– Mean that payment by such means is based on documents only, and not on

merchandise or services involved.

AMITY GLOBAL
BUSINESS SCHOOL Noida

Parties in LC Transaction
A transaction in a Letter of Credit may involved several parties from the issue of
the LC till making payment of the bills to the Seller:

•Applicant

–The buyer who finalizes the terms and conditions of purchase transaction and
submits a request to his bank for issuing a LC in favor of the seller.

•Beneficiary

–The beneficiary of the letter of credit is generally the seller of the goods and
services or the person in whose favor the credit has been issued.
AMITY GLOBAL
BUSINESS SCHOOL Noida

Parties in LC Transaction
• Issuing Bank / Opening Bank
– An issuing bank is the one which on receipt of request from its customer, the
applicant’s (purchaser’s) bank examines the proposal and open a LC in favor
of the beneficiary with the stipulated terms and condition.

• Advising Bank/ Correspondent Bank

– In case seller (beneficiary) resides in a different lace or in a foreign country,
the issuing bank may contact some other bank in the beneficiary’s country
may agree to advise the credit to the beneficiary and thus play the role of an
advising bank.
AMITY GLOBAL
BUSINESS SCHOOL Noida

Parties in LC Transaction
• Confirming Bank :
– The Confirming bank adds its guarantee to the credit opened by another bank,
thereby undertaking the responsibility of payment/negotiation acceptance
under the credit, in additional to that of the issuing bank. Confirming bank play
an important role where the exporter is not satisfied with the undertaking of
only the issuing bank.

• Reimbursing Bank
– Reimbursing Bank is the bank authorized to honor the reimbursement claim in
settlement of negotiation/acceptance/payment lodged with it by the negotiating
bank. It is normally the bank with which issuing bank has an account from
which payment has
AMITY GLOBAL
BUSINESS SCHOOL Noida

Parties in LC Transaction
• Nominated/ Negotiating Bank :
– The Negotiating Bank is the bank who negotiates the documents submitted to
them by the beneficiary under the credit either advised through them or restricted
to them for negotiation. On negotiation of the documents they will claim the
reimbursement under the credit and makes the payment to the beneficiary
provided the documents submitted are in accordance with the terms and
conditions of the letters of credit.

• Second Beneficiary:
– Second Beneficiary is the person who represent the first or original Beneficiary of
credit in his absence. In this case, the credits belonging to the original beneficiary
is transferable. The rights of the transferee are subject to terms of transfer.
AMITY GLOBAL
BUSINESS SCHOOL Noida

Parties in LC Transaction
AMITY GLOBAL
BUSINESS SCHOOL Noida
LC Mechanism
AMITY GLOBAL LC Mechanism
BUSINESS SCHOOL Noida

1st Principle of Letters of Credit: Letters of Credit are documentary

Step 1.
• The seller and the buyer enters into a sales contract where buyer agrees to
purchase goods from the seller. This agreement may be a purchase order, an
accepted pro-forma invoice, a formal contract, as to how and when goods are to be
shipped and insured, and how and when payment is to be effected. In this case
they agree that letter of credit will be used as the mechanism of payment.

Step 2.
• The buyer applies to his bank for a letter of credit in favor of the seller
(beneficiary), signing the bank’s letter of credit application/agreement form
specifying the terms and condition under which the Letter of Credit shall be
issued.

Step 3.
• After approving the application, the issuing bank issues the actual letter of credit
instrument and sends it to the beneficiary (the seller), thus undertaking the definite
obligation of effecting payment to the beneficiary upon presentation of documents,
strictly complying with the terms and condition of the credit .
AMITY GLOBAL LC Mechanism
BUSINESS SCHOOL Noida

2nd Principle of Letters of Credit: : Letters of Credit are independent

of any other contract or obligation.
Note: There are 3 separate contracts in a letter of credit transaction:
a) The contract of sale
b) The L/C application/agreement
c) The L/C itself.

Step 4.
• As soon as the seller receives Letter of Credit (issuing bank’s assurance of payment),
the seller ships the goods to the buyer provided the terms of credit meets the terms of
underlying sales contract.

Step 5 & 6.
• The seller prepares the documents called for in the letter of credit and presents them
to the Issuing bank. The issuing bank examines the documents whether they strictly
comply with the terms of letter of credit. If the documents meet the requirement the
issuing bank pays the beneficiary (seller) in the manner stipulated under the credit.
AMITY GLOBAL LC Mechanism
BUSINESS SCHOOL Noida

Step 7 & 8.
• The issuing bank sends the documents to the buyer (applicant) and obtains
payment in accordance with the terms of the applicant’s letter of credit
agreement ( usually by debit to the applicant’s account)

Step 9
• On receiving the documents from bank, the applicant (buyer) is in a position
to pick up the merchandise from the carrier, completing the letter of credit
cycle.
AMITY GLOBAL LC Mechanism
BUSINESS SCHOOL Noida
 AMITY GLOBAL LC Mechanism
BUSINESS SCHOOL Noida
• In case of Confirmed Letter of Credit the issuing bank invite another bank into the transaction,
having presence in the country of the seller. This second bank is called the confirming bank, it
will confirm the letter of credit issued by the issuing bank , and thus undertakes the primary
obligation to effect payment to the beneficiary (seller) [But if it merely informs the seller of the
LC without any obligation on its part they will just act as an advising bank]. They become a
third party to the letter of credit “contract” and have the right to refuse amendments.

For Conforming Bank

• When a bank adds their confirmation to a letter of credit, they are engaging to treat the letter of
credit as if they issued it themselves. If and when the beneficiary presents compliant documents
to the confirming bank, the confirming bank must pay. The confirming bank takes the risks of
being able to then collect payment from the issuing bank. [It may also act as a nominating bank,
if the LC calls for negotiation]

The major effect is to shift country risks to the confirming bank.

AMITY GLOBAL LC Mechanism
BUSINESS SCHOOL Noida
AMITY GLOBAL How LC works in Reality
BUSINESS SCHOOL Noida
Step 1.
•The buyer agrees to purchase goods from the seller using a letter of credit as the
mechanism of payment.
Step 2.
•The buyer applies to his bank for a letter of credit, signing the bank’s letter of credit
application/agreement form.
Step 3 a
•After approving the application, the issuing bank issues the actual letter of credit
instrument and forwards it to their chosen advising bank.
Step 3 a
•At the time the L/C is sent, the issuing bank also sends a reimbursement authorization
to their chosen reimbursing bank. This bank is the clearing bank the issuing bank uses
when making payments in the currency of the L/C and will play a role when the time
comes to pay the L/C.
AMITY GLOBAL How LC works in Reality
BUSINESS SCHOOL Noida
Step 4.
•The advising bank authenticates the letter of credit and delivers it to the
beneficiary (the seller). If the issuing bank has requested them to do so, the
advising bank may add their confirmation to the L/C (and thereby become the
confirming bank).
Step 5.
•Having received the issuing bank’s assurance of payment (and that of the
confirming bank if the L/C has been confirmed), the seller delivers goods to a
freight forwarder, who ships the merchandise to the buyer.
Step 6.
•The seller, the freight forwarder, and/or a document preparation company
prepares the documents called for in the letter of credit and presents them to
the “nominated bank.” The letter of credit may nominate a specific bank where
documents are to be presented or it may say it is “available with any bank,”
giving the seller the freedom to choose where to present documents. If the L/C
has been confirmed, documents must be presented to the advising/confirming
bank.
AMITY GLOBAL How LC works in Reality
BUSINESS SCHOOL Noida

Step 7.
• The nominated bank examines the documents and, if they comply, obtains
funds for payment to the beneficiary in accordance with the terms of the
letter of credit, generally by sending a reimbursement claim to the
reimbursing bank.

Step 8.
• The reimbursing bank matches the negotiating bank’s claim against the
reimbursement authorizations they are holding, charges the issuing bank’s
account, and transfers funds to the nominated bank.

Step 9 a & b.
• The nominated bank transfers payment to the beneficiary (seller) and
forwards the documents to the issuing bank.
AMITY GLOBAL How LC works in Reality
BUSINESS SCHOOL Noida
Step 10 a & b

•The issuing bank examines the documents. If it agrees with the nominated
bank that the documents comply with the letter of credit, the issuing bank
obtains payment from the applicant (buyer) in accordance with the terms of the
applicant’s letter of credit agreement and forwards the documents to the
applicant.

Step 11.

•The applicant (buyer) uses the documents to pick up the merchandise from the
carrier, completing the letter of credit cycle.
AMITY GLOBAL Types of Letter of Credit
BUSINESS SCHOOL Noida

• Revocable & Irrevocable Letter of Credit

– Irrevocable LC : A letter of credit is deemed to be an irrevocable
credit, which can neither be amended nor cancelled without an
express agreement of all the parties concerned. i.e. the applicant,
issuing bank, beneficiary and confirming bank (if any).
– *Revocable LC : The concept of “ Revocable Credit “ which was in
effect till UCPDC 500 (till 30th June, 2007) has been withdrawn
under the latest revision. Thus an LC can only be irrevocable in
nature.
AMITY GLOBAL
BUSINESS SCHOOL Noida

• Sight Credit & Acceptance (Usance) Credit

– Sight Credit : is the LC prescribes the condition of ‘ payment at sight ‘, in

this the beneficiary gets the benefit of immediate payment upon presentation of
the proper documents laid down as per the terms of LC at the paying bank.

– Usance Credit: If the beneficiary decides to grant a period of credit to

importer after sight such a LC is called Acceptance Credit. The period of credit
is called Usance, in this type of LC the beneficiary draws a usance draft on the
buyer or issuing bank or confirming bank depending on the terms. This draft is
presented along with documents and the beneficiary is advised that the
amount in the draft will be paid to him on prefixed future date .
AMITY GLOBAL
BUSINESS SCHOOL Noida

• Standby Letter of Credit

– standby letter of credit is the one which is opened for non-performance of some
activity it is very much similar in nature to a bank guarantee. The main objective
of issuing such a credit is to secure bank loans.

– Unlike a traditional letter of credit where the beneficiary obtains payment against
documents evidencing performance, the standby letter of credit allow a
beneficiary to obtains payment from a bank even when the applicant for the
credit has failed to perform as per the terms.

– Standby LC is payable only in case where an event had occurred but

performance for the event has not happened.
AMITY GLOBAL
BUSINESS SCHOOL Noida

• Standby Letter of Credit

– standby letter of credit is the one which is opened for non-performance of some
activity it is very much similar in nature to a bank guarantee. The main objective
of issuing such a credit is to secure bank loans.

– Unlike a traditional letter of credit where the beneficiary obtains payment against
documents evidencing performance, the standby letter of credit allow a
beneficiary to obtains payment from a bank even when the applicant for the
credit has failed to perform as per the terms.

– Standby LC is payable only in case where an event had occurred but

performance for the event has not happened.
AMITY GLOBAL
BUSINESS SCHOOL Noida

• Revolving Letter of Credit:

– Single L/C that covers multiple-shipments over a long period. Instead of
arranging a new L/C for each separate shipment,
– the buyer establishes a L/C that revolves either in value (a fixed amount is
available which is replenished when exhausted) or in time (an amount is
available in fixed installments over a period such as week, month, or
– This type of LC is used when the buyer needs shipments of the same
commodity at specified intervals e.g. monthly. It may revolve automatically or
subject to certain conditions.
– Example 1: Supply of coal to the iron industry is an ongoing material and
therefore as and when the goods are delivered, documents are submitted and
payment is made.
AMITY GLOBAL
BUSINESS SCHOOL Noida

For the next supply of coal, there is no new LC that is issued, rather the existing one
is "Reinstated" (bring back into use again) to the original amount.
– Assume that the supplier and the buyer agrees that 200MT of coal would be
delivered on a monthly basis for 12 months. The value of the LC for 200MT of coal
is Rs 12 lakhs . Every month 200MT of coal will be shipped and documents for Rs
12 lakhs would be submitted for payment. Once it get's paid in the first month, the
LC amount is automatically reinstated to Rs 12 lakhs for the next month's payment.

•Revolving L/Cs can be either cumulative or non-cumulative

Under a cumulative resolving L/C, the exporter is allowed to carry over any
amounts not drawn in previous periods. For example, if a revolving L/C is issued for
US$100,000 monthly, cumulative, and the exporter draws only USD80,000 in one
AMITY GLOBAL
BUSINESS SCHOOL Noida

month, the unutilized amount (i.e. USD20,000) may be carried over to next
month. That means the sum of US $120,000 becomes available the next
month.

Whereas under a non-cumulative revolving L/C, any amount not drawn

during a given period may not be available for drawing in next period. As in the
above example, the unutilized amount of USD20,000 can not be carried over
and added to the amount of next shipments, that means the exporter can draw
only US$100,000 in each succeeding month.

As per the Exchange Control Manual, revolving LCs should not be

established for import of goods into India without prior approval of RBI.
 AMITY GLOBAL
BUSINESS SCHOOL <Risk Assessment Noida

+
Positive
Letters of Credit
•Standby
•Commercial (Acceptances)
-
Negative

Cash in •Confirmed
Advance
•Insurance •Transferable
Vendor •Ex-Im Bank •Back-to-Back
Financing •CEFO •Assignment of Proceeds

Foreign Exchange
Foreign
Receivables
Exporter Neutral Importer
(Seller) (Buyer)
Zone
(Beneficiary) (Applicant)

-
ent

+
i pm
Sh Documentary
Open Account Collection 28
Negative Positive
AMITY GLOBAL
BUSINESS SCHOOL Noida

On the part of opening bank risk associated with Import LCs can be classified into :

• The financial standing of the Importer:

– he should be in a position to arrange for funds required at the time of retirement of bills
under LC. This involves an appraisal of the creditworthiness of the importer as a
borrower.
• Acceptability and saleability of the goods:
– This is a generic risk associated with all modes of international trade, and may affect
the importer’s ability to pay for his consignment.
• The status of the Exporter ( or beneficiary of the LC)
– This is the risk inherent in a situation that an errant exporter may ship substandard
goods.
AMITY GLOBAL
BUSINESS SCHOOL Noida

• Country Risk:

– This includes risk elements like the political and economical stability of a
country and exchange controls etc. Country Risk is however more pertinent
for exporters rather than importer..
• Foreign exchange Risk:

– A depreciation in the local currency vis-a-vis the transaction currency may

lead importer to pay more for the consignment than originally envisaged.

The disadvantage attached with the LC is that it assures correct documents

but not necessarily correct goods.
AMITY GLOBAL
BUSINESS SCHOOL Noida

– The communication in respect of documentary credit among the banks take

place through SWIFT (Society for Worldwide Inter-Bank Financial
Telecommunication) network.

– SWIFT provides secure network to banks and financial institution to transfer

financial transactions worldwide through a 'financial message'.
– SWIFT messages consist of five blocks of data including three headers,
message content, and a trailer.
– SWIFT messages are present and categorized in specific MT (Message
Type) numbers. MT are crucial to identifying content.
– Example: MT304

– The first digit (3) represents the category.

AMITY GLOBAL
BUSINESS SCHOOL Noida

A category denotes messages that relate to particular financial

instruments or services such as Precious Metals (6), Treasury (3), or
Travelers Cheques (8). The category denoted by 3 is Treasury Markets.
– The second digit (0) represents a group of related parts in a transaction
life cycle. The group indicated by 0 is a Financial Institution Transfer.
– The third digit (4) is the type that denotes the specific message. There
are several hundred message types across the categories. The type
represented by 4 is a notification.