Letter of Credit

What is a letter of credit?

A Letter of Credit (LC) is a document issued by your bank that
essentially acts as an irrevocable guarantee of payment to a
beneficiary. This means that if you do not perform your
obligations, your bank pays. The letter of credit can also be the
source of repayment of the transaction meaning that the exporter
will get paid with the redemption of the letter of credit.
Example:
For simplicity sake lets imagine that your company imports radios
from a Korean manufacturer called Seoul Manufacturin, which
banks at !irst Seoul "an#. Your company currently banks at !irst
$merican "an#
For the purpose of this example these will be the roles that the
parties will play in the letter of credit transaction:
%our company : applicant
Seoul Manufacturin : beneficiary
!irst $merican "an# : &ssuin "an#
!irst Seoul "an# : $dvisin "an#
The example: You want to buy !",""" worth of radios from #eoul
$anufacturing, which agrees to sell the merchandise and gi%es you
&" days to pay it with the condition that you pro%ide them with a
'" days letter of credit for the full amount. The steps to get the ()
would be as follows:
')You go to First American *ank and re+uest a !",""" letter of
credit with #eoul $anufacturing as a beneficiary.
()The bank goes through its underwriting process. Although the
bank is not ad%ancing money, they are extending credit on your
behalf and are taking on a contingent liability. ,f your company
+ualifies from a credit standpoint the () is issued.
))-%en if your company does not +ualify for credit, you can still
get an () if you are willing to put cash collateral ). secured
letters of credit are %ery common for small business .
*)The bank sends a copy of the letter of credit to First #eoul *ank,
which lets the %endor knows and the merchandise is shipped.
Take into consideration that the letter of credit itself might be the
source of repayment of
he transaction. ,t could be that #eoul $anufacturing is interested in
getting paid as soon as the merchandise is shipped. Therefore, the
letter of credit will indicate that payment shall be made as soon as
#eoul $anufacturing can present proof of shipping.
,f the letter of credit that your %endor re+uires is not tied to a
particular transactions, but they are asking for a guarantee that
makes sure that you will not default. They are probably asking for
a Stand+"y letter of credit or a ,evolvin letter of credit. These
types of ()s are usually for a longer term. /sually a year and are
the %endor0s guarantee that they will get paid.
The example abo%e describes the simplest of letter of credit
transactions. Although there are other factors in%ol%ed such as the
role of correspondent banks and confirmations, the thing that you
should be concerned as a customer is expediency and the fees
in%ol%ed, which can run anywhere from 1.!2 to 32 of the %alue of
the ()
-%.ES /! LE--E,S /! C,E0&-
,evocable letter of credit
4ust like the name says the () can be re%oked by the ,ssuing *ank
without the agreement of the beneficiary.
&rrevocable letter of credit
)an not be cancelled or amended without all the parties agreement.
Standby letter of credit
5uarantee of payment. ,f the beneficiary does not get paid from its
customer it can then demand payment from the *ank by
forwarding the copy of the in%oice that was not paid and
supporting documentation.
,evolvin letter of credit
,t is established when there are regular shipments of the same
commodity between supplier and customer. -liminates the need to
issue an () for each indi%idual transaction