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LRAB 2022 FREE IMPORTANT TOPIC – TYPES OF LETTERS OF CREDIT

LRAB 2022 FREE IMPORTANT TOPIC – TYPES OF LETTERS OF CREDIT

In this article, we will read about the LC as covered in the JAIIB LRAB 2022 Study Material as per the prescribed LRAB syllabus 2022. Take this article as the free Short Notes 2022.

LETTER OF CREDIT

An LC, Letter of Credit, is a bank guarantee that payment for the correct amount from the buyer will be received on time to the seller. 

And in case the buyer does not or is unable to make the payment for the purchases to the seller, the bank itself will cover the full amount on the remaining amount. Letter of credit can also be offered as a facility by the bank.

There are many factors that come in the way of international dealing such as laws of the country, distance and not knowing the parties personally, all these factors have made the use of a letter of credit an important aspect in international trade.

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FEATURES OF LETTER OF CREDIT

LC offers many benefits and has many features which are discussed below: 

  • These are issued against a security or collateral which could be in the form of a fixed deposit or a Bank deposit. 
  • Bank charges for certain fees which depend on the type of letter of credit that the customer is availing & is typically a % letter of credit’s size. 
  • Banks have to follow certain guidelines which are issued by the International Chambers of Commerce (ICC). 
  • Because in the issue of letter of credit only documental exchange and is no a transfer of goods or services, where it is important that all the mentioned details in the letter are correct and also includes in name of the Seller, amount, date, product name, and quantity, etc. 
  • The correctness of the letter of credit is important because banks can deny the payment if there is any slight mistake in the above-mentioned details. 
  • All the parties that are involved in the letter of credit are dealt with through documents therefore, the payment is not dependent on the defects found in goods and services.

IMPORTANCE OF LETTERS OF CREDIT

In international trade, because there are factors of distance, law, and the lack of any personal contact, the system of letters of credit has become an important mechanism for payment. 

This respect in international transactions is overseen by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits.

PARTIES TO A LETTER OF CREDIT

  • Importer, the applicant (who request the bank for the issue of letter of credit) 
  • The bank, that issues the letter of credit (also known as the opening banker of LC) 
  • Exporter, who is the beneficiary. 

WORKING OF LETTER OF CREDIT

Letter of credit operates as a negotiable instrument where the issuing Bank pays to the beneficiary. This way a letter of credit can also be transferred to another entity (through assignment) that gets the right to draw.

When a letter of credit is used in an international transaction, it signifies that payment will be made to the seller on time and of the full amount which has been granted by the issuing bank or the financial institution. Bank will charge fees and may also require Collateral from the buyer.

TYPES OF LETTERS OF CREDIT

Banks offer different types of letters of credit which one can avail depending on his or her requirement. Some of these letters of credit are discussed below:

Commercial Letter of Credit: Commercial LC office is a direct payment system where issuing Bank pays to the beneficiary. While in the case of standby LC, a secondary payment method is offered in which the bank pays to the beneficiary only when the purchaser or the holder of the LC cannot pay.

Revolving Letter of Credit: This type of LC enables a customer to use the letter for any number of purchases up to a certain limit fully specified period of time.

Traveler’s Letter of Credit: This type of LC is used by those who go abroad. This type of guarantee is one where the issuing bank will honor the drafts that will be made at foreign banks.

Confirmed Letter of Credit: In this type of letter of credit, a bank other than the issuing Bank guarantees the letter of credit. The second bank is typically the seller’s bank when it is known as a confirming bank. 

This confirming bank makes sure that the payment is made under the letter of credit if the holder or even the issuing bank makes default. This type of letter of credit is typically requested by the issuing bank in international transactions.

EXAMPLE OF A LETTER OF CREDIT

Suppose that the economic environment is unstable where it is difficult to obtain credit. State Bank of India will offer a buyer- the service of a letter of credit in which it will be guaranteed that the State Bank of India as the branch will pay for the purchase in case the holder defaults. 

Now every bank and the holder have an existing relationship, the bank already knows the creditworthiness, asset, and financial status of the holder of the letter of credit.

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DOCUMENTS REQUIRED TO OBTAIN A LETTER OF CREDIT

Following are some of the documents which are required to avail the facility of a letter of credit:

  • Duly filled form of the application attached with passport-sized photographs
  • KYC of the parties (through Passport, Aadhar Card, Voter ID card, Driving License, etc) involved: 
    • applicant, 
    • co-applicants, 
    • partners, 
    • directors 
  • Commercial Invoice
  • Bill of Exchange
  • Certificate of Origin
  • Original Health and Insurance certificates 
  • Financial Documents of Buyer
  • Documents related to Packing, Shipping, and Transport 
    • Landing airway bills, cargo receipts, etc.
  • Related Commercial documents: Inception Certificate
  • Other Official Documents which may be required by buyer’s/seller’s country
  • Any other document as may be required by the lender

This way a Letter of Credit is a document sent by the bank or financial institute guaranteeing that the seller will receive the payment for the goods or services that he/she/it has sold on time and for the full amount. Letters of credit are most often used in international trade as a security system for getting the payment. This is a good method where the parties can get the guarantee by paying a small fee.

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