INTERNATIONAL TRADE: THE LETTER OF CREDIT, PART III

INTERNATIONAL TRADE: THE LETTER OF CREDIT, PART III: "A letter of credit is simply another contract - a promise by Buyer's Bank which runs directly to Seller that Buyer's Bank will pay the sales..."

THE LETTER OF CREDIT, PART III

A letter of credit is simply another contract - a promise by Buyer's Bank which runs directly to Seller that Buyer's Bank will pay the sales contract amount to Seller, if Seller produces the documents required by the sales contract (i.e., a negotiable bill of lading). Letter of credit my be revocable or irrevocable, but in a documentary sales transaction it is customarily understood that an irrevocable one is required. Letters of credit may also be either confirmed or not. A confirmed letter of credit includes a promise from Seller's Bank to Seller that Seller's Bank will pay the contract amount to Seller if Seller produces the required documents evidencing shipment of the goods. Thus, under a confirmed letter of credit, Seller has a promise from a local bank, before shipment of the goods, of payment if the goods are shipped.

To obtain a letter of credit, the buyer goes to its bank and request it to issue a letter of credit in favor of the seller. The buyer has done business with this bank for many years, and it knows buyer's financial position, so no additional bank investigation is needed. However, if buyer was a stranger to the issuing bank, that bank would investigate buyer's credit standing, or even require it to provide the Bank  with a copy of its purchase orders or  with Seller's invoice, so that the bank will know what documents are required by the contract. The buyer's bank then informs its correspondent bank advising the latter that it has opened a letter of credit in favor of buyer, and stating all the details of the letter of credit contract.