How does a Letter of Credit work?

Definition:
“A letter of credit is a promise by a bank on behalf of the buyer (customer/importer) to pay the
seller (beneficiary/exporter) a specified sum in the agreed currency, provided that the seller
submits the required documents by a predetermined deadline.”

Importance of Letter of credit:

There are importer and exporter (Customer and Service Provider, in case of the domestic
transaction) deduce a business transaction where, supposedly, the importer (buyer) is willing to
buy goods form exporter (seller).
It may happen that buyer and seller are involving in business first time or wants to develop more
confidence in the transaction or the order carries huge amount and quantity which is capable of
causing acute financial hardships in case of any loss, the seller may demand agreement using
Letter of credit.

Steps in Letter of Credit: Import

transaction

The Contract of Sale

There should be a formal contract of sale agreed by both buyer and seller in specific sale terms
and conditions on which both parties are agreed upon. The contract of sale should include;
amount and type of goods with the description, the price for a single unit, delivery terms, the
format of currency, payment method and time allowed for document presentation and shipment.

Agreement and Application

There arises a contract of reimbursement and payment between the customer and the bank
who issued the letter of credit when the letter of credit of the bank application is executed. Only
in accordance with the instructions of the customer, the letter of credit is issued. There is the
constitution of agreement between the customer and issuing bank to reimburse issuing bank for
payment of drawings.
Letter of Credit issuance
The letter of credit was then prepared in accordance with the application by the issuing bank
and then forwarded to a branch or advising bank of the same issuing bank. The advising bank
gets instructions from issuing bank to add the confirmation of application or not as per the
instructions of the customer.

Confirming/Advising
The letter of credit than forwarded by the advising bank to the seller (beneficiary) with the
statement of no commitments conveyed on its part. However, it concluded with the examination
of documentary evidence where all the terms and conditions specified in letter of credit.

Contract of Sale
SELLER BUYER

Advice of letter of letter of credit

credit application

ADVISING/
CONFIRMING ISSUING BANK
BANK Request to advice
and, if applicable,
confirm letter of credit

Documents required in a letter of credit

There are many varieties and number of documents demanded in a letter of credit. The most
common documents required are the following:

Draft
A draft is a legally enforceable instrument an a bill of exchange which is, under the letter of
credit, a piece of formal debt evidence.
● A draft must consist of issuing bank’s name, number, date of drawing of the letter of
credit.
● Signed and drawn by the beneficiary (seller) of LC.
 ● The terms of the draft must be expressed in accordance with the tenor shown in the
letter of credit.
● The agreed amount within the balance which is available in the letter of credit with
equivalent currency which is given in the letter of credit.
● The amount must agree with the total amount of the invoices unless the letter of credit
stipulates that drafts are to be drawn for a given percentage of the invoice amount.

Commercial Invoice
It is a document used as a declaration of customs provided by the issuing bank to the
beneficiary (buyer).
● The description of goods in the letter of credit should be identical to the goods described
in the invoice.
● The letter of credit must consist of terms of shipping and unit price.

Customs Invoice
It is an extended form of the commercial invoice which is often required in the format specified
by customs.
● Should be signed and officially stamped by a consular officer of the country which is
importing.
● The value in commercial invoice must be agreed with the value of goods.

Bill of Lading
A bill of lading is a legal document between a shipper and a carrier that details the type,
quantity, and destination of the goods being carried.1
● Letter of credit must be stipulated by discharge and loading port.
● The manner of shipment must be consigned as per the letter of credit
● The authorized representative must sign this document from the receiver, shipper and
the carrier.

Air Waybill
An air waybill (AWB) is a document that accompanies goods shipped by an international courier
to provide detailed information about the shipment and allow it to be tracked.2
● Address and name of shipper and address and name of consignee;
● Three letters Designation and Origin airport code;
● Good’s description, custom’s value of the shipment, pieces number, gross weight, and
any other instructions which are necessary eg. if goods are perishable in nature.

1
https://www.investopedia.com/terms/b/billoflading.asp

2
https://www.investopedia.com/terms/a/airway-bill.asp
 ● Terms and conditions of the carrier (charges applicable, goods’ description, the
procedure of claims and limits of liability etc.)

Certificate or Insurance Policy

The buyer must be provided with a certificate or insurance policy from the beneficiary. The
extent of risks should be decided by the buyer and the seller at the initial agreement of contract
of sale.

Steps in Letter of credit: Export

transaction

Good’s shipment
The beneficiary should check the letter of credit after receiving it according to their satisfaction
that if all terms and conditions are fulfilled or not.after satisfaction the beneficiary can ship the
goods.

Documents presentation by Beneficiary

An invoice is prepared by the beneficiary with the stipulated description of goods given in the
letter of credit. The bill of landing then obtained by the beneficiary and prepares other
documents that are required in the letter of credit.

Sending documents to Issuing bank

Bank checks the documents and if they match the requirements to the letter of credit, the bank
will send the same to issuing bank, paying the seller and claiming reimbursement.

Documents delivery to the applicant

For acceptance, the issuing bank checks the documents and then it was delivered to the
applicant against the payment or as an undertaking to pay on the maturity of the drawing under
the letter of credit.3

3
Documentry Letters of Credit
 Goods
SELLER BUYER

Delivers documents
Documents Payment
and debits account

Documents
ADVISING/
CONFIRMING ISSUING BANK
BANK Reimbursement

Payment Procedure

Payment
“On presentation of the documents called for under the letter of credit, provided they are in
compliance with its terms, the advising/negotiating bank, in the case of an unconfirmed letter of
credit, may pay/negotiate the draft.
In the case of a confirmed letter of credit, the confirming bank is obliged to honor the drawing
without recourse to the beneficiary.”

Reimbursement
From issuing bank, the reimbursement will be claimed by negotiating/advising/confirming bank.

Sight Letter of Credit

A sight letter of credit is a document presented with all other necessary documents (once
payable) where payment of goods and services get verified

Unconfirmed Sight Letter of Credit

In this LC flow of payment of funds was from the buyer (applicant) to the seller (beneficiary).
 APPLICANT

ISSUING BANK

NEGOTIATING
BANK

BENEFICIARY

Confirmed Sight Letter of Credit

In this LC flow of payment of funds was also from the buyer (applicant) to the seller
(beneficiary). Although, payment is done without any recourse to the seller (beneficiary) by the
confirming/negotiating bank.
 APPLICANT

ISSUING BANK

NEGOTIATING/
CONFIRMING
BANK

BENEFICIARY

What to do on Dishonor of Documents

If the documents presented by the beneficiary was not in accordance with the letter of credit
then the following actions can be taken:
● If possible the documents may get corrected. Although, it is only applicable when all
inconsistency got corrected before the expiry of the letter of credit and before the
presentation of documents date.
● If the inconsistency cannot be corrected, from the issuing bank, the beneficiary bank can
demand authority to arrange draft despite inconsistencies.
● If the beneficiary wants immediate drawings than the conventional method can be
indemnity. Where the negotiating bank was then indemnified for the losses resulting,
principal amount and interest by the beneficiary.
● Ultimately, on an “approval” bases, documents can be sent to issuing bank.
 Parties involved in the transaction of
Letter of Credit
● Applicant: The goods and services sold by the seller are bought by the Applicant or the
one who requests for issuance of the letter of credit.

● Beneficiary: the one who sells the goods and provides services is beneficiary. On
behalf of the beneficiary, the letter of credit was addressed.

● Issuing bank: The bank who issue the letter of credit on the behalf of the applicant and
then transfer it to the Advising Bank to forward same to the beneficiary.

● Nominated bank: the Nominated bank is the bank with which the credit is available or
any bank in the case of a credit available with any bank.4

● Advising bank: the bank on the issuing bank’s request advises for credit is an Advising
bank

● Confirming bank: the bank who on request of authorization of issuing bank gives
confirmation to a credit.

Letter of credit (LC) and Letter of

undertaking (LoU)

Letter of undertaking
“LoU is a bank guarantee under which a bank allows its customer to raise money from another
Indian bank’s foreign branch in the form of short-term credit.”
The importers use this facility where LoU is treated as bank guarantee where a customer can
raise funds in the form of credit for Short-term from a foreign bank branch of another branch of
Indian Bank. Once the imported product/goods were received by the importer, the Indian bank
which has its branch in foreign transfer money to the supplier by foreign branch. The payment is
then made by the Indian buyer to the Indian branch which then transfers it to the Indian bank’s
foreign branch. Buyer is supposed to pay/deposit the money in the Indian branch, same does
not happen in PNB scam case which resulted in a huge fraud.

4
https://medium.com/@tradefinance/parties-involved-in-a-lc-transaction-b382d12049a8
The messages are sent through SWIFT. It is an interbank messaging network for securely
transmitting instructions for financial transactions.

RBI guidelines
● The Letter of Undertaking, due to PNB (Punjab National Bank) scam, was banned by
Reserve Bank of India where it was misused by fashion jewelry Nirav Modi.
● Due to this huge fraud, the committee decided to restore LoU and LoC issuance with
some safeguards.
● This discontinuation if LoUs and LoCs in banking sector set a conservatism effect and
result in 2-2.5% increment in the credit cost which will affect the country’s trade cost
competitiveness affecting jobs and employment.

Difference between LoC ad LoU

● The Letter of Credit has all the details of the importer, the purchase made by the
importer, expiry date, issuance date, the material purchased by the importer and other
details of the transaction. Hence, LoC’s are safer and secure.
● Just like what happened in PNB scam case, LoU’s does not consist of these details and
cannot be traced as it is not linked with the system of banking.