A letter of credit is a financing agreement most commonly used for trade arrangements where goods are crossing international borders. The letter is intended to facilitate the transfer of funds between the buyer and the seller.
Under this agreement, the bank of the importer (the "issuing bank") authorizes a letter of credit document under which the bank of the exporter will be paid a certain amount if specific conditions are met. The conditions are considered to have been met if the issuing bank is presented with an invoice and proof of delivery by the exporter's bank, as evidence that goods were shipped to the importer. The terms of the letter of credit may also state that other conditions be met, such as the delivery of a quality certificate and/or a certificate of insurance.
The party that controls the terms of the letter of credit is the issuing bank, which normally uses a standard form for this purpose.
When the requirements of the letter of credit have been met, the bank of the exporter pays the amount stated in the agreement. If this bank is unwilling to make the payment, it is designated the "advising bank," and merely forwards the evidence of shipment to the issuing bank. In this case, the issuing bank is also designated as the "nominated bank," and directly pays the exporter.
A special situation arises if the exporter is not certain that it will receive payment from the nominated bank. In this case, the exporter can ask its bank to confirm the letter of credit, which designates this bank as the "confirming bank" and makes it liable to pay the exporter upon the receipt of all required documentation. If confirmed, a letter of credit is then designated as a "confirmed letter of credit."
When a bank agrees to be designated as the confirming bank, it charges a fee for the service. The amount of the fee can be substantial, if the bank estimates that the issuing bank may not pay. If this risk is too high, it is possible that the bank will refuse to be designated as the confirming bank under any circumstances.
The issuing bank is the entity that normally pays out funds. To avoid any risk of nonpayment, the issuing bank may segregate funds in the importer's bank account, or designate a portion of the importer's line of credit for the payment of this liability.
The primary beneficiary in a letter of credit situation is the exporter, who is essentially guaranteed payment by a bank, as long as the required paperwork is submitted.
The standby letter of credit is a variation on the letter of credit concept. A standby letter of credit is intended to guarantee payment by a third party. This instrument is of great benefit to an entity that may have little credit history, if it can find an entity willing to post the letter of credit. This instrument is usually outstanding for a period of one year, after which it expires. The price charged for a standby letter of credit can be extremely high, especially if the credit quality of the buyer is considered questionable.