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Transaction Banking

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Letter of Credit
Letters of credit have evolved in the banking channel, to address the gap in risk management for both
buyers and sellers.

A Letter of Credit can be defined as:


• A payment undertaking given to the beneficiary (seller)
• By the issuing bank
• On behalf of the applicant (buyer)

To make payment to the seller, provided, the seller complies with the documentary requirements
specified in the letter of credit.

Parties in a LC Transaction

There are three parties who are essential to any LC transaction:

1. Applicant - The buyer- who starts the LC process


2. The LC Issuing Bank or LC Opening Bank (Buyer’s Bank) - Provides the payment guarantee
3. Beneficiary - Seller

The LC issuing bank does not provide for any cash outflow at the time of issuing an LC. However, the
bank exposes itself to credit risk in case the applicant (its customer) does not pay on the due date.

Advising Bank – An LC issued by the issuing bank is communicated to the beneficiary by a bank in the
beneficiary’s country. This process is known as LC advising, and the bank which communicates the LC
issuance is known as the ‘advising bank’.

Confirming Bank – When another bank in the exporter’s country, adds its payment confirmation to the
LC already issued by the buyer’s bank, this process is known as LC confirmation, and the bank which
adds its payment confirmation to an existing LC is known as the ‘confirming bank’.

Documents

• Once the exporter receives the LC, he proceeds with making the shipment ready for export.
• He arranges for all the documentation called for under the LC.
• The shipment and the documentation have to comply with all the terms and conditions in the LC
perfectly.

Discrepant Documents - Documents not in compliance with LC terms and conditions are known as
‘discrepant documents’. The LC issuing bank and the applicant can reject payment for the LC in case of
discrepancies, however minor.

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Transaction Banking
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Some clauses under an LC and the documentation that evidence compliance/non-compliance


for them -

i. Last date of shipment – Date of bill of lading


ii. Shipment from, shipment to – Bill of lading
iii. LC expiry date – Bank stamp on documents submitted by exporter
iv. Goods description – Invoice
v. Quantity of goods – Bill of Lading, Invoice
vi. Goods specification – Inspection certificate, Certificate of Origin
vii. Quality of goods – Quality certificate
viii. Insurance coverage – Insurance Policy/Certificate

Other Parties in an LC Transaction

Depending upon how an LC is settled, there could be additional parties to the LC process.

• Negotiating Bank - A negotiating bank checks documents for credit compliance, pays the
exporter, and then claims reimbursement from the issuing bank.
• Paying Bank - A paying bank checks documents for credit compliance, claims money from the
Issuing bank, and then pays the exporter.
• Accepting Bank - A bank becomes the LC accepting bank, if it accepts the Bill-of-Exchange drawn
on itself by the exporter.

The Advising Bank can also choose to be the Negotiating/Paying/Accepting Bank.

LC Process Flow

The LC process can be split into two legs – issuance and settlement (or utilization).

Issuance
1. The applicant submits the LC issuance request to the issuing bank.
2. The issuing bank issues the LC and transmits the same to the advising bank.
3. The advising bank authenticates the LC, and
4. Advises the same to the beneficiary.

Settlement
1. The goods as matching with the description provided in the LC are shipped by the beneficiary in
the mode described, and before the last date of shipment as prescribed by the credit.
2. The documents complying with the terms and conditions of the LC are submitted to the accepting
bank nominated in the LC, before expiry of time period specified for the same.
3. The accepting bank verifies the documents for compliance of LC terms and forwards them to the
LC issuing bank.
4. The LC issuing bank confirms credit compliance of the documents and releases payment under the
LC to the beneficiary.

©Finitiatives Learning India Pvt. Ltd. (FLIP), 2010. Proprietary content. Please do not misuse!
Transaction Banking
A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

5. The issuing Bank debits the applicant’s account for the LC amount and releases the documents for
taking delivery of the goods.

Types of LCs

1. Revocable/Irrevocable LCs - A revocable LC is one which can be cancelled without the consent of
the beneficiary. On the other hand, an ‘irrevocable LC’ can be cancelled only with the express consent
of the beneficiary.

2. Confirmed/Unconfirmed LC – It is one where a bank other than the LC issuing bank has added
their payment confirmation. The request for confirmation is originated by the LC issuing bank to one
of their correspondent banks in the exporter’s country, who then adds their payment confirmation to
the LC.

3. Sight LC - A sight LC is similar to a D/P (delivery against payment) transaction, where the issuing
bank pays to the beneficiary immediately on presentation of credit compliant documents. There is no
credit period involved in the transaction.

4. Usance LC - The issuing bank accepts a Bill-of-Exchange drawn on itself under the LC and makes
payment to the beneficiary/beneficiary’s bank on the maturity of the bill. The beneficiary, on the
other hand, is able to obtain quick financing for such accepted bills as they are secured by a payment
guarantee of the issuing bank. It incorporates a credit period.

Special Types of LCs


1. Transferable LCs : If the exporter is only a trader sourcing from another seller, the LC might allow
part or all of the credit to be available to the ultimate seller.
2. Back-to-Back LCs : The exporter might ask his bank to establish another LC to the ultimate supplier,
on the back of the LC received from the ultimate buyer.
3. Revolving LCs : The LC is reinstated each time the same is utilized, eliminating the need for re-
issuance. A revolving LC can be based on time, or on value.
4. Red-clause LCs : These LCs are used to provide an advance to the exporter by the buyer.
5. Stand-by LCs: They protect against non-performance or non-happening of a particular event.

Uniform Customs and Practices for Documentary Credit (UCPDC) lays down guidelines for banks to follow
while processing transactions relating to opening, advising, confirming, negotiating and settling Letters of
Credit.

©Finitiatives Learning India Pvt. Ltd. (FLIP), 2010. Proprietary content. Please do not misuse!

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