Accounting Dictionary

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Letter of Credit

Definition: A letter of credit is an arrangement where an importer’s bank (the issuing bank) formally authorizes an obligation to pay the exporter’s bank during a specific period of time, assuming that several documented conditions have been met.  The documents that must be presented to the issuing bank include an invoice and proof of delivery.  In addition, a certificate of insurance may be required, as well as a quality certificate.  The issuing bank creates the letter of credit, and so has control over its terms.

When all terms of the letter of credit have been completed, the exporter presents all required documents to its bank, which pays the exporter the amount noted in the letter of credit.  If the exporter’s bank is unwilling to make this payment, then it is called the advising bank, and merely passes along the documentation to the issuing bank, which is now designated as the nominated bank, and makes the payment.  If the exporter is uncertain of the reliability of the nominated bank, it may ask its own bank to confirm the letter of credit.  If the bank agrees, then it is designated as the confirming bank, and enters into an agreement to pay the exporter immediately following receipt of the required documents.  Upon completion of this step, the letter of credit is said to be a confirmed letter of credit.  A bank charges a fee in exchange for being the confirming bank.  This fee can be quite high if a banker feels that there is a significant risk of the issuing bank failing to pay, and a banker may refuse confirmation entirely if the risk is perceived to be excessively high.

The key party in making a letter of credit work is the issuing bank, which is guaranteeing the credit.  In order to do so, this bank may block out a portion of its line of credit to the importer, which it will not release until the letter of credit transaction has been completed, and the bank has been paid by the importer.

The letter of credit is useful for the importer, who receives proof of title to the goods, as well as evidence that the goods have been shipped.  However, the real benefit goes to the exporter, who obtains a guarantee of payment from a bank, which is a distinct improvement over a guarantee of payment from the importer.