Bank letters of credit have been in existence since the medieval era. The two major types include the commercial letters of credit and the standby letters of credit. Each of these letters is designed to serve a specific purpose which is honored by the parties involved in the transaction. Letters of credit are ruled by their basic international norms.
WHAT ARE LETTERS OF CREDIT?
A letter of credit is a document from a bank to a seller to guarantee that the buyer’s payment will be received by the bank and be made available to the seller at the appropriate amount and time. In a situation that the buyer fails to pay the seller on time, the bank will bear the responsibility of settling the debt.
Letters of credits are among the most used methods of payment and funding for international trades. The letter is issued to the seller on behalf of the buyer to guaranty the supplier that the monetary value of the goods will be paid based on the terms and conditions in the letter. If there had been errors, once they are resolved and the supplier has complied with the terms and conditions contained in the document, the money will be paid and the transaction closed.
Letters of credit are of different types. In situations that would demand a backup plan, a standby letter of credit will provide more security than the usual commercial or standard letters of credit. It will interest you that there is the tendency for things to go wrong in any transaction irrespective of the type and thus is the need for a standby letter of credit.
WHAT IS A STANDBY LETTER OF CREDIT?
A standby letter of credit is a document created by the bank to serve as an assurance that the beneficiary will be paid if anything goes amiss during the transaction. The document will contain the conditions by which the money will be paid.
Standby letters of credit are preferred for both local and international business transactions and in building projects.
A letter of credit is a guarantee provided by the bank to generate trust between the parties involved in the transaction.
In a situation that the buyer who is a customer of the bank backs off on his part by failing to pay on time or complete a project based on the agreements, the bank will make the recovery in such a situation by paying the beneficiary.
However, the funds will be owned by the customer who had requested for an issuance of the letter of credit but it is the duty of the bank to pay the beneficiary.
HOW CAN YOU OBTAIN A STANDBY LETTER OF CREDIT?
The following steps are involved when you are requesting for a standby letter of credit from a bank:
- You must show adequate proves that you can pay the loan.
- The bank may require a collateral which will serve as a security.
- The decision of the bank will be provided to you writing within a week based on their satisfaction with the documents presented by you.
- For each of the years that the Standby Letter of Credit remains valid, you will pay a fee.
- The fee you will pay will be about 1-10% of the total monetary value of the letter.
- Once the prescribed arrangements are followed, you can cancel the Standby Letter of Credit without attracting extra charges.
WHAT ARE THE TYPES OF STANDBY LETTER OF CREDIT?
The three types of the standby letter of credit are:
- Financial Standby Letter of Credit
- Performance Standby Letter of Credit
- Revolving letter of credit
FINANCIAL STANDBY LETTER OF CREDIT: This is an irrevocable guarantee by the bank to the supplier that the payment will be made if the buyer fails in its responsibility of payment. It is because the financial standby letter of credit has a 100% conversion factor which implies that bank must pay the beneficiary its due amount.
PERFORMANCE STANDBY LETTER OF CREDIT: this is an undertaking by the bank to pay the beneficiary on the condition that the buyer has failed in completing his transaction obligations. This letter of credit is based on contractual performance and has a 50% conversion. This implies that the bank will make payment of 50% value of the deal to the beneficiary where the client fails to complete the payment.
REVOLVING LETTER OF CREDIT: this is a document issued by the bank to facilitate long-term business transactions between an importer and an exporter. It involves multiple shipment contracts which may span into years.
WHAT IS THE NEED FOR THE ISSUANCE OF LETTERS OF CREDIT?
The ability of the buyer to make payments for the goods and services bought is one of the most important factors for consideration in international trade. However, suppliers may be interested in a detailed assurance that they will be paid once the goods are delivered to the purchaser. This assurance can only be provided by the bank. Therefore, letters of credits serve the following purposes:
- Letters of credit provide the seller with the guarantee of being paid on behalf of the buyer.
- Letters of credit reduce the risks that are mostly common in international trade.
- With Letters of credit, the buyer and the seller are provided with renewed confidence and trust on the smoothness of their transactions.
- The amount of money that will be credited to the seller are clearly stated in the document give more credence to the business.
WHAT ARE THE RULES THAT GOVERN LETTERS OF CREDIT?
Letters of credits are governed based on the laws contained in the “Uniform Customs and Practice for Documentary Credits (UCP)”. This is set of rules recognized at the international markets for trade on credits. The UCP was published by the International Chambers of Commerce (ICC) in 1933 and was recently revised in 2007.
Legal status has not been provided for the UCP in any country of the world. They are simple guidelines to facilitate best practices in International Trades.
WHO ARE THE PARTIES TO LETTERS OF CREDIT?
The parties are those that have genuine obligations under the terms of the letters of credit and does not include the “Applicant”. It should interest you that the letters of credit are a direct commitment between the bank and the beneficiary. The applicant or the buyer is only a third party and is not involved in the letters of credit. The parties are the issuing bank, the confirming bank and the beneficiary.
WHAT ARE THE TYPES OF LETTERS OF CREDIT?
The types of letters of credit are:
- Clean letters of credit
- Documentary letters of credit
CLEAN LETTERS OF CREDIT: this is a letter of credit which is neither a Financial nor a Commercial document.
DOCUMENTARY LETTERS OF CREDIT: documentary letters of credits are letters that are used along with financial documents and commercial documents.
WHAT ARE THE PROCESSES INVOLVED IN THE ISSUANCE OF LETTERS OF CREDIT?
This involves the detailed steps that must be initiated by all the parties in the transaction which are necessary for the establishment of the letters of credit.
- The buyer and the seller will reach an agreement that the terms of their transactions be settled by letters of credit.
- The buyer will apply to the bank along with the copies of the Sale Contract for the issuance of letters of credit.
- The buyer’s bank on acceptance of the client’s application will issue a letter of credit to the seller through another bank which is likely the beneficiary’s bank.
- A copy of the letters of credit will be issued to the applicant by the bank. The buyer will then examine the documents to confirm if they are in conformity with the earlier agreement they had with the seller. If there are discrepancies, such will be reported to the issuing bank which will in turn make the necessary corrections. The seller on the other end, will be provided with the same opportunity given to the buyer through its bank.
- The advising bank will be in the position to provide the necessary information and interpretation of the terms in the document to the beneficiary. Thus, the advising bank will confirm the document once it has agreed to comply with the requests of the issuing bank.
- If the beneficiary is not satisfied with the content of the letters of credit he has received, the advising bank will be notified and the applicant or the issuing bank will make the appropriate corrections.
- Any amendment that has been suggested by the seller to the buyer must be communicated to the issuing bank which will make an assessment for the necessary compliance.
- On no account shall an amendment become a working document until it is accepted by the buyer. All amendments must be communicated to the buyer through the advising bank.
WHAT ARE THE DIFFERENCES BETWEEN A STANDBY LETTER OF CREDIT AND OTHER LETTERS OF CREDIT
A standby letter of credit is issued by the bank to the seller is a guarantee of the creditworthiness of the buyer. A standard or commercial letter of credit has some similarities with a standby letter of credit. In both cases, the bank provides the buyer with a guarantee of payment once they are satisfied with the documents provided by the buyer.
Below are what makes a Standby Letter of Credit different from other Letters of Credit:
BACKUP: A standby letter of credit provides a backup to the seller that nothing can go wrong. Even though something goes wrong in the part of the buyer that he fails to pay the supplier, the backup plan ensures that the buyer receives his complete payment. The Standby Letter of credit creates the hope that payment will be made in the heart of the seller. Once the seller has successfully delivered the supply, he is sure to get his money.
PERFORMANCE: standby letters of credit comes with a performance component that states the condition for payment. In the negative performance as may be preferred, if the service is not completed, the beneficiary will still be paid.
LOCAL TRANSACTIONS: they are mostly used for domestic transactions. Examples include building projects, road constructions and other services for the government.