LETTERS OF CREDIT

Chapter 7Sias International University

International SettlementsFall 2011

WHAT IS A LETTER OF CREDIT?

SIMPLY STATED:

A LETTER OF CREDIT IS A “LETTER” FROM ONE BANK (the issuing bank) TO ANOTHER BANK ( the beneficiary bank) INSTRUCTING THE SECOND BANK TO DO SOMETHING (IAW the request and instructions of the buyer who is the applicant)… for a fee.

LETTERS OF CREDIT• Banks do NOT have to issue letters of credit; they do

so as an accommodation to their customers. Even though banks charge for their “service”, they are doing the business a “favor.”

• Getting an L/C is great.

• Giving an L/C may be painful

TWO BASIC TYPES OF LETTERS OF CREDIT

• International• Generally more flexible and less costly• Especially if drawn on a bank outside of the US• Must deal with Currency Issues!!!

• Domestic• Some limitations in the US due to US banking laws• Not used very extensively• Generally take money from Buyer’s account when opened!

DICOTOMIZING L/Cs• Revocable L/Cs• Can Be Terminated at Will or by the Occurrence of

Some Event

• Irrevocable L/Cs• Can Not Be Terminated by the issuing party.• Most are Irrevocable!

• di·chot·o·my•    [dahy-kot-uh-mee] Show IPA • noun, plural -mies. 1. division into two parts, kinds, etc.; subdivision into halves or pairs. • 2. division into two mutually exclusive, opposed, or contradictory groups: a dichotomy between thought and action .

DICOTOMIZING L/Cs• Documented L/Cs• Means That Merchandise is Involved• Inspection Certificate, etc. (3rd Party)

• Clean Letters of Credit• Means “Clean” of Documentation- no merchandise

involved.

• Confirmed L/C• Means that a Local Bank has the Authority to pay on the

L/C.

• Non-Confirmed L/C• Means that the Local Bank must send the paperwork to the

originating country for approval and only after that approval is given will the local bank pay on the L/C.

• Beware … in Developing Countries!!

DICOTOMIZING L/Cs

• “Actual” L/C• One on which money will be paid if the proper

documentation exists—No Ifs.

• Stand-by L/Cs• Substituting your bank’s balance sheet for your (possibly

anemic) balance sheet. Bank does not expect to pay on this.

DICOTOMIZING L/Cs

General Features of an L/C

• Buyer/Writer … Seller/Beneficiary• Issuing Bank … Advising Bank• Amount … Which Currency

• % of Purchase Price• “At Sight” … Deferred payment• Partial Shipment?• Transfer of “Title” … FOB, CIF, CF, etc.• Documents … i.e. Inspection Certificate

• Remember banks pay only on paperwork!!• Special Instructions … i.e. latest shipment date, who

pays for amendments, etc.

An International L/C… Example/Tricks

• An American wants to buy from a firm in Hong Kong.

• How would he/she pay for the merchandise?

• Send the seller an L/C, payable, say, in 60 days.

If the Holder of an L/C that is not payable on “Sight” wants his/her money now, he or she can discount the draft at the Banker’s Acceptance Rate. The Bank can keep the discounted note or endorse it and sell it in the money market.

An International L/C… Example/Tricks

An International L/C… Example/Tricks

What’s Beautiful About That?

The Bankers Acceptance Rate might be two points below Prime. This is instead of financing Receivables at, say, two points above Prime. A swing of, perhaps, four points….

An International L/C… Example/Tricks

…and the interest saving can be even greater if the L/C is made payable in a country with lower interest rates. Where the Banker’s Acceptance Rate might be 11% in Hong Kong, it might be 6.1% here or, even better, in Japan where the rate might be 1 or 2%.

Doing Business without a Substantial Balance Sheet

Back-to-Back Letters of Credit

How to do business on someone else’s balance sheet

On the strength of a L/C you receive you can ask your bank to issue a L/C for you

Unfortunately, most American banks don’t like to do this; they think this is the equivalent of a credit commitment.

Doing Business without a Substantial Balance Sheet

A Transferable L/C

• Banks prefer this method today.

• If the L/C you receive is “transferable,” then you can ask your bank to “transfer” the L/C to your supplier.

• In doing this the bank can change two things: the dollar amount and the termination date. • This way you can get your “mark-up.”

Doing Business without a Substantial Balance Sheet

Assignment of Proceeds

• In this case, your bank issues your supplier an “Assignment of proceeds” for the amount of money you owe to your supplier; when the bank collects on the LC, it transfers the amount due to your supplier.

• This is tough to do in developing countries, e.g., China, as they are not familiar with this.

Clean Letters of Credit

• Means “clean” of documentation, i.e.., no merchandise.

• Two basic purposes• To make payments

• For “guarantees”

Examples of Clean L/C … Used as a “Guarantee”

• In lieu of bonding for project finance• For Performance … Bond normally cheaper

• To guarantee notes or bonds

• When using clean L/Cs as “guarantees,” what you are really doing is changing the “apparent risk”.

Costs of L/Cs

• Issuing Bank charges about $25 to $100 for writing the letter plus a percentage of the dollar amount, for example, 3/8ths% to 1.5%.• The % can vary substantially• Big difference between US and European Banks• Also charges for amendments

• Advising Bank also imposes charges

Using L/Cs with a revolving line of credit

• Be Careful!

• Customer might ship when you don’t want him/her to ship.

In addition to L/Cs:

Banks can provide a collection service

Documents on Payment (DP)

Documents on Approval (DA)

LETTERS OF CREDIT

END

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