Letters of credit accomplish their purpose by substituting the credit of the bank for that of the customer, for the purpose of facilitating trade. There are basically two types: commercial and standby which may be for national or international use.
The commercial letter of credit is the primary payment mechanism for a transaction, whereas the standby letter of credit is a secondary payment mechanism.
Commercial letters of credit have been used for centuries to facilitate payment in international and national 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 payor. As with guaranteeing payment to a manufacturer of goods to produce a product which has been sold to a company by a supplier that need to fill a purchase order from that company. The letter of credit is issued by the supplier's bank to the manufacturer guaranteeing the cost of raw materials, labor and delivery to the company which ordered it. Upon delivery of the product, the manufacturer can collect the full amount covered by the guarantee at the supplier's bank.
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. Standby letters of credit are issued by banks to stand behind monetary obligations, to ensure the refund of advance payment, to support performance and bid obligations, and to ensure the completion of a sales contract. The credit has an expiration date.
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 as Credit Lines 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 credit.
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 or UCC. Under these provisions, the bank is given until the close of the third banking day after receipt of the documents to honor the draft.
Revolving Letter of Credit
This kind of letter allows a customer to make any number of draws within a certain limit during a specific time period.
Traveler's Letter of Credit
For those going abroad, this letter will guarantee that issuing banks will honor drafts made at certain foreign banks.
Confirmed Letter of Credit
A confirmed letter of credit involves a bank other than the issuing bank guaranteeing the letter of credit. The second bank is the confirming bank, typically the seller's bank. The confirming bank ensures payment under the letter of credit if the holder and the issuing bank default. The issuing bank in international transactions typically requests this arrangement. For some requiring the use of a bank committed guarantee, they have elected to use the services of private international banks with an appetite for trying to project the financial comfort enjoyed by customers pledging huge deposits of capital for the privilege to use guarantees issued by US banks. And, since every private bank guarantee transaction isn't scheduled to result in the liquidation of the guarantee, the system can work.
Contact All Commercial Finance for bank guarantees for any purpose.