Entrepreneurs operating in international markets may encounter the term bank letter of credit. This tool is quite often used primarily in the case of trade, but it works well wherever we are faced with the desire to secure our interests. What is a bank letter of credit? How much does it cost? What to pay attention to and is it worth using it?
The concept of a bank letter of credit most often appears in the aspect of international agreements, but we can also meet with it when providing services or trading in the local / domestic market. Wherever a third party, which in this case is a bank, can be helpful to secure a transaction.
Before explaining what a bank letter of credit is, it is worth noting in two sentences that financial institutions (banks) provide many different services to consumers and businesses, which are not always associated only with accounts or loans. In fact, among the banking services we can find, among other things, sureties, bank guarantees, collection or just the letters of credit in question. The latter mainly concern entrepreneurs who want to protect themselves in case a counterparty fails to fulfill a contract.
What is a bank letter of credit?
The mechanism of operation of a letter of credit, despite its initially meaningless name, is really extremely simple. This is because a bank letter of credit is a kind of form of payment that occurs when the conditions are met by a party to a counterparty agreement. The letter of credit is intended to secure the contracting party in the event of a possible default by the other party.
What is a letter of credit and for what purpose is it used?
The best example describing the operation of letters of credit will be international trade between two counterparties: an exporter (e.g., manufacturer, wholesaler) and an importer (recipient of goods or services). In a situation where an importer orders products from an exporter, there is no certainty, the manufacturer will fulfill its part of the contract, i.e. deliver the goods on time and to the place indicated by the importer. Admittedly, appropriate contracts are usually concluded for this purpose, but enforcing them internationally can be extremely tedious and costly.
This is where a letter of credit will be ideal, thanks to which the funds earmarked for payment for the ordered goods will be credited to the exporter’s account only after the exporter has fully fulfilled its part of the contract. That’s when the importer’s bank will make the transfer to an account held at the exporter’s bank.
As you can see, the letter of credit secures the interests of the recipient of the goods/services, but it can also work the other way around. If the manufacturer is not sure that the importer will pay for the goods (e.g., he refuses to pay in advance), the bank will make the funds belonging to the importer available automatically, after delivery of the goods.
A bank letter of credit thus secures both one side of the transaction and the other.
Letter of credit in practice
Once we understand what a bank letter of credit is and the purpose for which it is used, it is also worth touching on how the whole procedure of activating it looks like. As a rule, a bank letter of credit is ordered at the opening bank by the importer (recipient of the goods), as he is the payer and the funds will be released from his account. After determining the exact terms of the agreement and when the funds will be transferred to the exporter, the bank blocks the amount / value of the transaction in the importer’s account.
At the next stage, the opening bank notifies the exporter’s bank of the establishment (opening) of the letter of credit, which is equivalent to the ability to start the process of delivery of goods / provision of services. Information about the opening of the letter of credit is a kind of confirmation that the money will be sent when the exporter fulfills his part of the contract.
Once the terms of the letter of credit are met, the opening bank transfers the funds blocked in the importer’s account to the exporter’s account and the contract is closed.
Bank letter of credit, parties and documents
In a bank letter of credit a total of four parties are involved. These are:
- the principal (importer / recipient of goods or services);
- The principal’s bank, which opens the letter of credit;
- the beneficiary of the letter of credit, i.e. the seller or exporter;
- the beneficiary’s bank (exporter), which informs the beneficiary of the opening of the letter of credit.
Documents required to receive payment.
In order for the opening bank to transfer the funds blocked in the recipient’s account, it is necessary to submit certain documents to the institution. These include commercial invoices, waybills or other documents confirming the transport of goods, certificates of origin, quality certificates, insurance documents, among others.
It is worth noting at this point that each commercial contract involves different products or services, so the parties can establish any documentation necessary for the execution of a bank letter of credit.
Bank letter of credit – benefits and costs
The main advantage of a bank letter of credit is to increase the security of the transaction, by making payment only after both parties have met the conditions specified in the trade agreement. With a bank letter of credit, the importer gains certainty of receipt of goods, of the ordered quality, quantity and at the specified date and place. The exporter, on the other hand, gains certainty of payment for goods delivered / services rendered.
Costs of a bank letter of credit
Depending on the bank, the costs of a bank letter of credit are divided into several different fees, such as a commission or document verification fee and a fee for confirming the letter of credit. As for the commission, it usually ranges from 0.2 to 0.3 percent of the transaction value, but it all depends entirely on the bank’s policy. Which party will be charged for the letter of credit is also determined on a case-by-case basis.
