MECHANISM IN LETTER OF CREDIT

While dealing by an individual or entity in different countries, both seller and buyer do not have confidence on each other. Buyer would insist delivery of goods first and would like to pay after receipt of goods. But Seller on the other side would like to act on the contrary; he would like to receive funds first and then would like to send the goods.

So in this situation there would not be any trade.

Since bank enjoys a repute of trust and confidence, so it acts as guarantor to both seller and buyer.

It provides guarantee to seller that in case the goods are shipped to the buyer, he would definitely get the value of goods. Similarly the buyer would be guaranteed that he would get the goods according to the worth of his money.

This bridge of confidence is built by at least two bankers, i.e. banker of seller and banker of buyer, and this trust are managed by way of an instrument known as “Letter Of Credit”. And no doubt for providing such facility, both bankers earn by way of charges those are either borne by buyer, seller or both of them as agreed mutually between buyer and seller.

COMMENTARY ON SKETCH FOR MECHANISM OF A LETTER OF CREDIT.

Buyer directly contacts with the seller to know about the cost of merchandise; buyer intends to buy. It is known as enquiry.

Seller would offer the rates of the goods and other terms. If those rates and terms are agreed by both of them, they enter into a

written agreement. On the basis of that agreement buyer requests his bank to send a letter on

his behalf to the seller to dispatch as per agreement. That agreement contains name, brand, colour , model, size, number of items, rates, mode of transportation; indicating who would bear the cost of transportation and Insurance premium amount, validity of offer and approximate date/period of shipment of goods.

Bank sends a letter addressed to the seller (Not The Bank Abroad), requesting seller to dispatch goods as per terms of this letter, and after shipment submit set(s) of documents, having proof of shipment of goods to a bank; nominated by the buyer’s bank. The most important document is “Document Title to Goods” like Airway Bill, Bill of Lading. Railway Receipt and Post Parcel Receipt etc. The document depends upon the mode of transportation agreed between buyer and seller and it is specifically contained in the letter. This letter is known as Letter of Credit.

A copy of this letter is mailed to foreign bank, which would accept documents from seller.

No doubt that the letter is addressed to the seller, but it is not mailed to the seller directly, but through the bank abroad, and buyer’s bank request the seller’s bank to hand over this letter to the seller.

Why not to dispatch to seller directly. This letter specifically guarantee/undertake to make the payment to the

seller immediately after shipment or on future fixed date if agreement is to pay on usance basis.

Now seller is confident that he would surely get the payment for the goods he would be selling some one abroad, and with whom he has no other relations and even not knowing buyer otherwise.

Seller would dispatch the goods, would prepare set(s) of documents mentioned in letter of credit and would submit to the bank abroad. That bank after thorough scrutiny would debit the account of buyer’s bank (if value of letter of credit is stated in the currency of seller’s bank) or if the currency is alien currency to that bank than that seller’s bank would claim the amount from other bank on behalf of buyer’s bank and it would be paid, as in this a copy of this letter of credit is also mailed to that third bank; authorizing that bank to honour the claim of seller’s bank.(THIS POINT IS TO BE ELABORATED MORE IN SESSION)

Seller’s bank after making payment to the seller would dispatch documents to the bank of buyer. At this point one end of the guarantee is settled as the seller got his

value for the goods he sold. Now the goods are coming to the country of buyer; through Air Craft or

Ship and simultaneously the documents are also traveling from the country of seller to the country of buyer.

The goods have been shipped in favour of buyer’s bank and only that bank is entitled to get the goods released from the carrier or by a nominee

of buyer’s bank. Reason being the buyer’s bank has made the payment to the seller and this value is yet to be received from the buyer.

On receipt of documents the buyer’s bank would intimate the buyer and would request buyer to come and collect documents; after making payment in local currency.

As discussed in class that in Pakistan when goods are imported our importer makes payment in Local currency, where as the buyer’s bank account was debited in foreign currency. It indicates that the bank has made payment on behalf of buyer and this payment would be termed as “Sale of Foreign Currency” to the buyer.

Later on buyer would come and would authorize it’s bank to debit his account and hand over the documents, and to remind you these are the documents on the basis of those the seller received the value of his goods, and now when the these are being handed over to the buyer; bank would get it’s money.

As already stated that Goods were shipped in the favour of buyer’s bank and only that bank or its nominee is entitled to get the goods released. So after receiving money from buyer, the buyer’s bank would authorize the buyer to get the goods cleared and take its delivery. This process of transferring the title of goods is done through endorsement.

Now the final end of the guarantee is also settled as the buyer would get the goods against the value he paid.

This transaction was only possible through an undertaking given by the bank and is called “Letter of Credit”

BANKING TERMINOLOGIES FOR ABOVE STATED DEALING

Until now we have been using layman/easy language just to make the students understand effortlessly. But we being heading toward getting expertise in International Banking, we must be acquainted with real Banking terms and those are:-

Document which serves the purpose of offer from beneficiary, in which descriptionof goods, with price, brand colour, model and other terms are stated, signed by theexporter, and later on when importer accepts itby signing on its face and submits to the opening bank as an agreement for establishmentof letter of credit. Performa Invoice

Buyer Importer/Opener of L/c

Seller. Exporter/Beneficiary

Buyer’s Bank Opening Bank.

Seller’s Bank through whom L/c was sent. Advising Bank

Seller’s Bank when making payment to seller. Negotiation Bank

The bank from which negotiating bankclaim reimbursement in case of other currencyknown as third bank Reimbursing Bank

Process whereby negotiating bank checksdocuments in terms of L/c before making payment To exporter Negotiation

Finally we must know “What is a Letter of Credit” ?

It is an instrument in shape of a letter issued on behalf of the opener, by opening bank; addressed to the beneficiary, having an undertaking that he would get the value of goods shipped by him, but strictly in terms of letter of Credit.

OTHER RELATED TERMINOLOGIES

FOB Free on board

C&F Cost and Freight

CIF Cost Insurance and Freight