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Management of Financial Institutions

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Management of Financial Institutions - MGT 604
Lecture # 29
Letter of Credit
Commercial Letter of Credit
Commercial letters of credit have been used for centuries to facilitate payment in
international trade. Their use will continue to increase as the global economy evolves.
Letters of credit used in international transactions are governed by the International
Chamber of Commerce Uniform Customs and Practice for Documentary Credits. The
general provisions and definitions of the International Chamber of Commerce are binding
on all parties. Domestic collections in the United States are governed by the Uniform
Commercial Code.
A commercial letter of credit is a contractual agreement between a bank , known as the
issuing bank, on behalf of one of its customers, authorizing another bank, known as the
advising or confirming bank, to make payment to the beneficiary. The issuing bank, on the
request of its customer, opens the letter of credit. The issuing bank makes a commitment to
honor drawings made under the credit. The beneficiary is normally the provider of goods
and/or services. Essentially, the issuing bank replaces the bank's customer as the payee.
Elements of a Letter of Credit
A payment undertaking given by a bank (issuing bank)
On behalf of a buyer (applicant)
To pay a seller (beneficiary) for a given amount of money
On presentation of specified documents representing the supply of goods
Within specified time limits
Documents must conform to terms and conditions set out in the letter of credit
Documents to be presented at a specified place
The beneficiary is entitled to payment as long as he can provide the documentary evidence
required by the letter of credit. The letter of credit is a distinct and separate transaction from
the contract on which it is based. All parties deal in documents and not in goods. The
issuing bank is not liable for performance of the underlying contract between the customer
and beneficiary. The issuing bank's obligation to the buyer, is to examine all documents to
insure that they meet all the terms and conditions of the credit. Upon requesting demand for
payment the beneficiary warrants that all conditions of the agreement have been complied
with. If the beneficiary (seller) conforms to the letter of credit, the seller must be paid by the
Issuing Bank
The issuing bank's liability to pay and to be reimbursed from its customer becomes absolute
upon the completion of the terms and conditions of the letter of credit. Under the provisions
of the Uniform Customs and Practice for Documentary Credits, the bank is given a
reasonable amount of time after receipt of the documents to honor the draft.
The issuing banks' role is to provide a guarantee to the seller that if compliant documents
are presented, the bank will pay the seller the amount due and to examine the documents,
and only pay if these documents comply with the terms and conditions set out in the letter of
Management of Financial Institutions - MGT 604
Typically the documents requested will include a commercial invoice, a transport document
such as a bill of lading or airway bill and an insurance document; but there are many others.
Letters of credit deal in documents, not goods.
Advising Bank
An advising bank, usually a foreign correspondent bank of the issuing bank will advise the
beneficiary. Generally, the beneficiary would want to use a local bank to insure that the
letter of credit is valid. In addition, the advising bank would be responsible for sending the
documents to the issuing bank. The advising bank has no other obligation under the letter of
credit. If the issuing bank does not pay the beneficiary, the advising bank is not obligated to
Confirming Bank
The correspondent bank may confirm the letter of credit for the beneficiary. At the request
of the issuing bank, the correspondent obligates itself to insure payment under the letter of
credit. The confirming bank would not confirm the credit until it evaluated the country and
bank where the letter of credit originates. The confirming bank is usually the advising bank.
Letter of Credit Characteristics
Letters of credit are usually negotiable. The issuing bank is obligated to pay not only the
beneficiary, but also any bank nominated by the beneficiary. Negotiable instruments are
passed freely from one party to another almost in the same way as money. To be negotiable,
the letter of credit must include an unconditional promise to pay, on demand or at a definite
time. The nominated bank becomes a holder in due course. As a holder in due course, the
holder takes the letter of credit for value, in good faith, without notice of any claims against
it. A holder in due course is treated favorably under the UCC.
The transaction is considered a straight negotiation if the issuing bank's payment obligation
extends only to the beneficiary of the credit. If a letter of credit is a straight negotiation it is
referenced on its face by "we engage with you" or "available with ourselves". Under these
conditions the promise does not pass to a purchaser of the draft as a holder in due course.
Letters of credit may be either revocable or irrevocable. A revocable letter of credit may be
revoked or modified for any reason, at any time by the issuing bank without notification. A
revocable letter of credit cannot be confirmed. If a correspondent bank is engaged in a
transaction that involves a revocable letter of credit, it serves as the advising bank.
Once the documents have been presented and meet the terms and conditions in the letter of
credit, and the draft is honored, the letter of credit cannot be revoked. The revocable letter
of credit is not a commonly used instrument. It is generally used to provide guidelines for
shipment. If a letter of credit is revocable it would be referenced on its face.
Management of Financial Institutions - MGT 604
The irrevocable letter of credit may not be revoked or amended without the agreement of
the issuing bank, the confirming bank, and the beneficiary. An irrevocable letter of credit
from the issuing bank insures the beneficiary that if the required documents are presented
and the terms and conditions are complied with, payment will be made. If a letter of credit is
irrevocable it is referenced on its face.
Transfer and Assignment
The beneficiary has the right to transfer or assign the right to draw, under a credit only when
the credit states that it is transferable or assignable. Credits governed by the Uniform
Commercial Code (Domestic) maybe transferred an unlimited number of times. Under the
Uniform Customs Practice for Documentary Credits (International) the credit may be
transferred only once. However, even if the credit specifies that it is nontransferable or no
assignable, the beneficiary may transfer their rights prior to performance of conditions of
the credit.
Sight and Time Drafts
All letters of credit require the beneficiary to present a draft and specified documents in
order to receive payment. A draft is a written order by which the party creating it, orders
another party to pay money to a third party. A draft is also called a bill of exchange.
There are two types of drafts: sight and time. A sight draft is payable as soon as it is
presented for payment. The bank is allowed a reasonable time to review the documents
before making payment.
A time draft is not payable until the lapse of a particular time period stated on the draft. The
bank is required to accept the draft as soon as the documents comply with credit terms. The
issuing bank has a reasonable time to examine those documents. The issuing bank is
obligated to accept drafts and pay them at maturity.
Standby Letter of Credit
The standby letter of credit serves a different function than the commercial letter of credit.
The commercial letter of credit is the primary payment mechanism for a transaction. The
standby letter of credit serves as a secondary payment mechanism. A bank will issue a
standby letter of credit on behalf of a customer to provide assurances of his ability to
perform under the terms of a contract between the beneficiary. The parties involved with the
transaction do not expect that the letter of credit will ever be drawn upon.
The standby letter of credit assures the beneficiary of the performance of the customer's
obligation. The beneficiary is able to draw under the credit by presenting a draft, copies of
invoices, with evidence that the customer has not performed its obligation. The bank is
obligated to make payment if the documents presented comply with the terms of the letter of
Standby letters of credit are issued by banks to stand behind monetary obligations, to insure
the refund of advance payment, to support performance and bid obligations, and to insure
the completion of a sales contract. The credit has an expiration date.
Management of Financial Institutions - MGT 604
The standby letter of credit is often used to guarantee performance or to strengthen the
credit worthiness of a customer. In the above example, the letter of credit is issued by the
bank and held by the supplier. The customer is provided open account terms. If payments
are made in accordance with the suppliers' terms, the letter of credit would not be drawn on.
The seller pursues the customer for payment directly. If the customer is unable to pay, the
seller presents a draft and copies of invoices to the bank for payment.
The domestic standby letter of credit is governed by the Uniform Commercial Code. Under
these provisions, the bank is given until the close of the third banking day after receipt of
the documents to honor the draft.
Procedures for Using the Tool
The following procedures include a flow of events that follow the decision to use a
Commercial Letter of Credit. Procedures required to execute a Standby Letter of Credit are
less rigorous. The standby credit is a domestic transaction. It does not require a
correspondent bank (advising or confirming). The documentation requirements are also less
Step-by-step process:
Buyer and seller agree to conduct business. The seller wants a letter of credit to
guarantee payment.
Buyer applies to his bank for a letter of credit in favor of the seller.
Buyer's bank approves the credit risk of the buyer, issues and forwards the credit to
its correspondent bank (advising or confirming). The correspondent bank is usually
located in the same geographical location as the seller (beneficiary).
Advising bank will authenticate the credit and forward the original credit to the
seller (beneficiary).
Seller (beneficiary) ships the goods, then verifies and develops the documentary
requirements to support the letter of credit. Documentary requirements may vary
greatly depending on the perceived risk involved in dealing with a particular
Seller presents the required documents to the advising or confirming bank to be
processed for payment.
Advising or confirming bank examines the documents for compliance with the terms
and conditions of the letter of credit.
If the documents are correct, the advising or confirming bank will claim the funds
Debiting the account of the issuing bank.
Waiting until the issuing bank remits, after receiving the documents.
Reimburse on another bank as required in the credit.
Advising or confirming bank will forward the documents to the issuing bank.
Issuing bank will examine the documents for compliance. If they are in order, the
issuing bank will debit the buyer's account.
Issuing bank then forwards the documents to the buyer.
Management of Financial Institutions - MGT 604
Standard Forms of Documentation
When making payment for product on behalf of its customer, the issuing bank must verify
that all documents and drafts conform precisely to the terms and conditions of the letter of
credit. Although the credit can require an array of documents, the most common documents
that must accompany the draft include:
Commercial Invoice
The billing for the goods and services. It includes a description of merchandise, price, FOB
origin, and name and address of buyer and seller. The buyer and seller information must
correspond exactly to the description in the letter of credit. Unless the letter of credit
specifically states otherwise, a generic description of the merchandise is usually acceptable
in the other accompanying documents.
Bill of Lading
A document evidencing the receipt of goods for shipment and issued by a freight carrier
engaged in the business of forwarding or transporting goods. The documents evidence
control of goods. They also serve as a receipt for the merchandise shipped and as evidence
of the carrier's obligation to transport the goods to their proper destination.
Warranty of Title
A warranty given by a seller to a buyer of goods that states that the title being conveyed is
good and that the transfer is rightful. This is a method of certifying clear title to product
transfer. It is generally issued to the purchaser and issuing bank expressing an agreement to
indemnify and hold both parties harmless.
Letter of Indemnity
Specifically  indemnifies  the  purchaser  against  a  certain  stated  circumstance.
Indemnification is generally used to guaranty that shipping documents will be provided in
good order when available.
Common Defects in Documentation
About half of all drawings presented contain discrepancies. A discrepancy is an irregularity
in the documents that causes them to be in non-compliance to the letter of credit.
Requirements set forth in the letter of credit cannot be waived or altered by the issuing bank
without the express consent of the customer. The beneficiary should prepare and examine
all documents carefully before presentation to the paying bank to avoid any delay in receipt
of payment. Commonly found discrepancies between the letter of credit and supporting
documents include:
Letter of Credit has expired prior to presentation of draft.
Bill of Lading evidences delivery prior to or after the date range stated in the credit.
Stale dated documents.
Management of Financial Institutions - MGT 604
Changes included in the invoice not authorized in the credit.
Inconsistent description of goods.
Insurance document errors.
Invoice amount not equal to draft amount.
Ports of loading and destination not as specified in the credit.
Description of merchandise is not as stated in credit.
A document required by the credit is not presented.
Documents are inconsistent as to general information such as volume, quality, etc.
Names of documents not exact as described in the credit. Beneficiary information
must be exact.
Invoice or statement is not signed as stipulated in the letter of credit.
When a discrepancy is detected by the negotiating bank, a correction to the document may
be allowed if it can be done quickly while remaining in the control of the bank. If time is
not a factor, the exporter should request that the negotiating bank return the documents for
If there is not enough time to make corrections, the exporter should request that the
negotiating bank send the documents to the issuing bank on an approval basis or notify the
issuing bank by wire, outline the discrepancies, and request authority to pay. Payment
cannot be made until all parties have agreed to jointly waive the discrepancy.
Tips for Exporters
Communicate with your customers in detail before they apply for letters of credit.
Consider whether a confirmed letter of credit is needed.
Ask for a copy of the application to be fax to you, so you can check for terms or
conditions that may cause you problems in compliance.
Upon first advice of the letter of credit, check that all its terms and conditions can be
complied with within the prescribed time limits.
Many presentations of documents run into problems with time-limits. You must be
aware of at least three time constraints - the expiration date of the credit, the latest
shipping date and the maximum time allowed between dispatch and presentation.
If the letter of credit calls for documents supplied by third parties, make reasonable
allowance for the time this may take to complete.
After dispatch of the goods, check all the documents both against the terms of the
credit and against each other for internal consistency.
Table of Contents:
  1. Financial Environment & Role of Financial Institutions:FINANCIAL MARKETS &INSTITUTIONS
  2. FINANCIAL INSTITUTIONS:Non Banking Financial Companies
  3. CENTRAL BANK:Activities and responsibilities, Interest Rate Interventions
  4. POLICY INSTRUMENTS:Open Market Operations, Capital Requirements
  5. BALANCE OF TRADE:Balance of Payments Equilibrium, Public Policy and Financial Stability
  6. STATE BANK OF PAKISTAN:History, Regulation of Liquidity, Departments
  10. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Human Resources Department
  13. PAKISTAN ECONOMIC AID & DEBT:Macroeconomic Stability, Strengthening Institutions
  14. INCREASING FOREIGN DIRECT INVESTMENT:Industrial Sector, Managing the Debt
  15. ROLE OF COMMERCIAL BANKS:Services Typically Offered by Banks, Types of banks
  16. ROLE OF COMMERCIAL BANKS:Types of investment banks, The Management of the Banks
  17. ROLE OF COMMERCIAL BANKS:Public perceptions of banks, Capital adequacy, Liquidity
  19. ROLE OF COMMERCIAL BANKING:Private Deposit Insurance,
  20. BRANCH BANKING IN PAKISTAN:Remittances, Online Fund Transfer
  22. Mutual funds:Types of international mutual funds, Mutual funds vs. other investments
  23. Mutual Funds:Criticism of managed mutual funds, Money Market Fund
  24. Mutual Funds:Balanced Funds, Growth Funds, Specialized Funds, Measuring Risks
  25. Mutual Funds:Cost of Ownership, Redemption Fee, Reports to Shareholders
  26. Mutual Funds:Internet Fraud, The Pyramid Scheme, How to Avoid Investment Fraud
  27. Mutual Funds:Investing In International Mutual Funds, How to Pre-Select a Mutual Fund
  28. Role of Investment Banks:Recent evolution of the business, Possible conflicts of interest
  29. Letter of Credit:Elements of a Letter of Credit, Commercial Invoice, Tips for Exporters
  30. Letter of Credit and International Trade:Terminology, Risks in International Trade
  31. Foreign Exchange & Financial Institutions:Investment management firms, Exchange Traded Fund
  32. Foreign Exchange:Factors affecting currency trading, Economic conditions include
  33. Leasing Companies:Basic Purpose of Leasing, Technological Benefits
  34. The Leasing Sector in Pakistan and its Role in Capital Investment
  35. Role of Insurance Companies:Indemnification, Insurer’s business model
  36. Role of Insurance Companies:Life insurance and saving
  37. Role of financial Institutions in Agriculture Sector:What is “Revolving Credit Scheme”?
  38. Agriculture Sector and Financial Institutions of Pakistan:What is SMEs
  39. Can Government of Pakistan Lay a Pivotal Role in this Sector?:Business Environment
  40. Financial Crimes:Process of Money Laundering, Terrorist Financing
  41. DFIs & Risk Management:Managing Credit Risk, Managing Operational Risk
  42. Banking Fraud & Misleading Activities:Rogue Traders, Uninsured Deposits
  43. The Collapse of ENRON:Auditing Issues, Corporate Governance Issues, Corrective Actions
  44. Classic Financial Scandals:Corruption, Discovery, Black Wednesday