Lesson 32 Letter Of Credit-Banking and Finance-Handout, Exercises of Banking and Finance

Download Lesson 32 Letter Of Credit-Banking and Finance-Handout and more Exercises Banking and Finance in PDF only on Docsity! LESSON 32 LETTER OF CREDIT International Banking and International Trade complementary to each other. Facilitating international trade is the most important activity of international banking. Exporter (seller) and Importer (buyer) are two important players in international trading activity. What the seller (exporter) wants Contract fulfillment (payment) Convenience (of receiving payment in a bank in his own country) Prompt Payment Expert Advice. What the buyer (Importer) wants Contract fulfillment (Goods) Convenience of using an intervening third party in whom both have confidence, such as a bank. Credit -possibility of obtaining finance. Expert advice and assistance. Letter of credit provides the mechanism to fulfill the above requirements of exporters and importers. Letter of Credit A Letter of Credit is a payment term generally used for international sales transactions. It is basically a mechanism, which allows importers/buyers to offer secure terms of payment to exporters/sellers in which a bank (or more than one bank) gets involved. The technical term for Letter of credit is 'Documentary Credit'. At the very outset one must understand is that Letters of credit deal in documents, not goods. The idea in an international trade transaction is to shift the risk from the actual buyer to a bank. Thus a LC (as it is commonly referred to) is a payment undertaking given by a bank to the seller and is issued on behalf of the applicant i.e. the buyer. The Buyer is the Applicant and the Seller is the Beneficiary. The Bank that issues the LC is referred to as the Issuing Bank which is generally in the country of the Buyer. The Bank that Advises the LC to the Seller is called the Advising Bank which is generally in the country of the Seller. The specified bank makes the payment upon the successful presentation of the required documents by the seller within the specified time frame. Note that the Bank scrutinizes the 'documents' and not the 'goods' for making payment. Thus the process works both in favor of both the buyer and the seller. The Seller gets assured that if documents are presented on time and in the way that they have been requested on the LC the payment will be made and Buyer on the other hand is assured that the bank will thoroughly examine these presented documents and ensure that they meet the terms and conditions stipulated in the LC. How Letters of Credit Can Help You Build Your Business Letters of credit are a time-honored instrument for trade finance. We have found them useful for any number of import deals. The usefulness of documentary letters of credit, for instance, derives from the fact that they provide mutual protection for both the importer and the exporter. As everyone engaged in international trade knows, anything that removes headaches is generally a good thing. Documentary letters of credit are also handy for commodity-type transactions. docsity.com Letters of Credit -- a Solution to Many Trade Finance Needs Letters of credit are tools to aid importers to leverage their capital base and their ability to capture more trading opportunities. A Letter of Credit allows importers/buyers to offer secure terms of payment to exporters/sellers in which a bank (or more than one bank) gets involved. The technical term for Letter of credit is 'Documentary Letter of Credit'. Letters of Credit (LC's) deal in documents, not goods. The idea in an international trade transaction is to shift the risk from the actual buyer to a bank. Thus an LC is a payment undertaking given by a bank to the Beneficiary (the seller) and is issued on behalf of the applicant (the buyer). The Bank that issues the LC is referred to as the Issuing Bank, generally in the country of the Buyer. The Bank that Advises the LC to the seller is called the Advising Bank which is generally in the country of the seller. The specified bank makes the payment upon the successful presentation of the required documents by the seller within the specified time frame. Note that the Bank scrutinizes the 'documents' and not the 'goods' for making payment. This process gives both the buyer and the seller comfort that the transfer of ownership to the goods will occur properly and when payment is secure. The seller gets assured that if documents are presented on time and in the way that they have been requested on the LC the payment will be made. The buyer is assured that the bank will thoroughly examine these presented documents and ensure that they meet the terms and conditions stipulated in the LC. Documents requested in a Letter of Credit would often include: a commercial invoice; a transport document such as a Bill of lading or Airway bill; an insurance document; an inspection certificate; and/or a certificate of origin. Other documents could be required, depending on the underlying transaction. Keep in mind that the Letter of Credit process revolves around documents, not goods. The LC could be 'irrevocable' or 'revocable'. An irrevocable LC cannot be changed unless both the buyer and seller agree. Whereas in a revocable LC changes to the LC can be made without the consent of the beneficiary. A 'sight' LC means that payment is made immediately to the beneficiary/seller/exporter upon presentation of the correct documents in the required time frame. A 'time' or 'date' LC will specify when payment will be made at a future date and upon presentation of the required documents A letter of credit can make a big difference to an importer. Many international deals just can't happen without a letter of credit. And when you cut through all the mumbo-jumbo.......this is a tool that allows buyers and sellers to do business with greater confidence. Method of Financing International Trade: Letter of credit is one of the methods of financing international trade, there are other methods of financing international trade and those are outlined and explained below: o Open account method o Documentary collection and o Payment in advance/ Cash in advance Open Account Method An open account transaction means that the goods are shipped and delivered before payment is due, usually in 30 to 90 days. Obviously, this is the most advantageous option to the importer in cash flow and cost terms, but it is consequently the highest risk option for an exporter. Because of the intense competition for export markets, foreign buyers often press exporters for open account terms. In addition, the extension of credit by the seller to the buyer is more common abroad. Therefore, exporters who are reluctant to extend credit may face the possibility of the loss of the sale to their competitors. However, while this method of payment will definitely enhance export competitiveness, exporters should thoroughly examine the political, economic, and commercial risks, as well as cultural influences to ensure that payment will be received in full and on time. It is possible to substantially mitigate the risk of nonpayment associated with open account trade by using such trade finance techniques as export credit insurance and factoring. Exporters may also wish to seek export working capital financing to ensure that they have access to financing for both the production for export and for any credit while waiting to be paid. docsity.com Key Points  Full or significant partial payment is required, usually via credit card or bank/wire transfer, prior to the transfer of ownership of the goods.  Cash-in-advance, especially a wire transfer, is the most secure and favorable method of international trading for exporters and, consequently, the least secure and attractive option for importers. However, both the credit risk and the competitive landscape must be considered.  Insisting on these terms ultimately could cause exporters to lose customers to competitors who are willing offer more favorable payment terms to foreign buyers in the global market.  Creditworthy foreign buyers, who prefer greater security and better cash utilization, may find cash-in-advance terms unacceptable and may simply walk away from the deal. Wire Transfer—Most Secure and Preferred Cash-in-Advance Method An international wire transfer is commonly used and has the advantage of being almost immediate. Exporters should provide clear routing instructions to the importer when using this method, including the name and address of the receiving bank, the bank’s SWIFT, Telex, and ABA numbers, and the seller’s name and address, bank account title, and account number. This option is more costly to the importer than other options of cash-in-advance method, as the fee for an international wire transfer is usually paid by the sender. When to Use Cash-in-Advance Terms  The importer is a new customer and/or has a less-established operating history.  The importer’s creditworthiness is doubtful, unsatisfactory, or unverifiable.  The political and commercial risks of the importer’s home country are very high.  The exporter’s product is unique, not available elsewhere, or in heavy demand.  The exporter operates an Internet-based business where the use of convenient payment methods is a must to remain competitive. In International trade, the buyer and the seller who are located in different countries, may not know each other and hence many times the problem of Buyer’s Creditworthiness hampers the trade between the buyer and the seller. The main objectives of the buyer and the seller in any international trade and contradictory in terms of Buyer will always try to delay the payment while the seller would like to receive funds at the earliest. To mitigate this problem, Seller always request Buyer to arrange for a Letter of Credit to be issued by Buyer’s Bank. Upon issuance of Letter of Credit, the Buyer’s bank replaces its own Creditworthiness to that of the Buyer, it undertakes to reimburse the Seller for the value of the Letter of Credit “Irrevocably” provided two underline conditions are fulfilled by the Seller: 1. All the documents stated in the LC are presented; 2. All the terms and conditions of the LC are complied with. The beauty of the LC is that if above two conditions are fulfilled, Issuing Bank will effect payment to the Beneficiary, irrespective of Applicant reimburses the Issuing Bank or not. Thus, a Letter of Credit is an undertaking issued by a bank in favor of a Beneficiary (Seller), which substitutes the bank’s creditworthiness for that of the Applicant (Buyer). Why Letter? It is named a Letter because initially the LCs were issued manually in a Letter format address by Issuing Bank to Beneficiary confirming its conditional undertaking to reimburse the Beneficiary, the amount of the LC provided above 2 basic conditions are fulfilled. Letter of Credit---General Definition: docsity.com ‘A letter of credit can be defined as an instrument issued by a bank in which the bank furnishes its credit which is both good and well known, in place of the buyer’s credit, which may be good but is not so well known. A bank issues a letter of credit on behalf of one of its customers authorizing an individual or firm to draw draft (bill of exchange) on the bank or one of its correspondents for the bank’s account under certain conditions stipulated in the credit. Definition of L.C (Article 2 of UCP 600) Credit means any arrangement, however named or described that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honor a complying presentation. Complying presentation: means a presentation that is in accordance with the terms and conditions of the credit, the applicable provisions of these rules and international standard banking practice. Article 2 of the ICC, Uniform Customs and Practices, brochure 500 (UCP-500) defines a letter of credit as: ‘Any arrangement however named or described, whereby a bank issues a letter of credit on behalf of a customer the “Applicant “or on its own behalf, Is to make payment to or to the order of a third party (the beneficiary) or is to accept and pay bills of exchange (draft) drawn by the beneficiary or Authorizes another bank to effect such payment or to accept and pay such bills of exchange (draft) or Authorizes another bank to negotiate against stipulated documents, provided the terms and conditions of the credit are complied with. We shall continue with the this topic in coming Lesson docsity.com