Letters Of Credit

LETTERS OF CREDITLETTERS OF CREDIT

Chapter 12Chapter 12

WHAT IS A LETTER OF WHAT IS A LETTER OF CREDIT?CREDIT?

SIMPLY STATED:SIMPLY STATED:

A LETTER OF CREDIT IS A “LETTER” FROM A LETTER OF CREDIT IS A “LETTER” FROM ONE BANK TO ANOTHER INSTRUCTING ONE BANK TO ANOTHER INSTRUCTING THE SECOND BANK TO DO SOMETHING … THE SECOND BANK TO DO SOMETHING … for a fee.for a fee.

LETTERS OF CREDITLETTERS OF CREDIT

Banks do Banks do NOTNOT have to issue letters of have to issue letters of credit; they do so as an accommodation credit; they do so as an accommodation to their customers. Even though banks to their customers. Even though banks charge for their “service”, they are charge for their “service”, they are doing the business a “favor.”doing the business a “favor.”

Getting an L/C is great.Getting an L/C is great.

Giving an L/C may be painfulGiving an L/C may be painful

TWO BASIC TYPES OF TWO BASIC TYPES OF LETTERS OF CREDITLETTERS OF CREDIT

InternationalInternational– Generally more flexible and less costlyGenerally more flexible and less costly– Especially if drawn on a bank outside of the USEspecially if drawn on a bank outside of the US– Must deal with Currency Issues!!!Must deal with Currency Issues!!!

DomesticDomestic– Some limitations due to US banking lawsSome limitations due to US banking laws– Not used very extensivelyNot used very extensively– Generally take money from Buyer’s account when Generally take money from Buyer’s account when

opened!opened!

DICOTOMIZING L/Cs

Revocable L/Cs– Can Be Terminated at Will or by the

Occurrence of Some Event

Irrevocable L/Cs– Can Not Be Terminated by the

issuing party.– Most are Irrevocable!

DICOTOMIZING L/Cs

Documented L/Cs– Means That Merchandise is Involved– Inspection Certificate, etc. (3rd Party)

Clean Letters of Credit– Means “Clean” of Documentation- no

merchandise involved.

Confirmed L/C– Means that a Local Bank has the Authority to

pay on the L/C.

Non-Confirmed L/C– Means that the Local Bank must send the

paperwork to the originating country for approval and only after that approval is given will the local bank pay on the L/C.

– Beware … in Developing Countries!!Beware … in Developing Countries!!

DICOTOMIZING L/Cs

“Actual” L/C– One on which money will be paid if the proper

documentation exists—No Ifs.

Stand-by L/Cs– Substituting your bank’s balance sheet for

your (possibly anemic) balance sheet. Bank does not expect to pay on this.

DICOTOMIZING L/Cs

General Features of an L/C

Buyer/Writer … Seller/BeneficiaryBuyer/Writer … Seller/Beneficiary Issuing Bank … Advising BankIssuing Bank … Advising Bank Amount … Which CurrencyAmount … Which Currency

– % of Purchase Price% of Purchase Price ““At Sight” … Deferred paymentAt Sight” … Deferred payment Partial Shipment?Partial Shipment? Transfer of “Title” … FOB, CIF, CF, etc.Transfer of “Title” … FOB, CIF, CF, etc. Documents … i.e. Inspection CertificateDocuments … i.e. Inspection Certificate

– Remember banks pay only on paperwork!!Remember banks pay only on paperwork!! Special Instructions … i.e. latest shipment Special Instructions … i.e. latest shipment

date, who pays for amendments, etc.date, who pays for amendments, etc.

An International L/C… Example/Tricks

An American wants to buy from a firm in Hong Kong.

How would he/she pay for the merchandise?

Send the seller an L/C, payable, say, in 60 days.

If the Holder of an L/C that is not payable on “Sight” wants his/her money now, he or she can discount the draft at the Banker’s Acceptance Rate. The Bank can keep the discounted note or endorse it and sell it in the money market.



What’s Beautiful About That?

The Bankers Acceptance Rate might be two points below Prime. This is instead of financing Receivables at, say, two points above Prime. A swing of, perhaps, four points….


…and the interest saving can be even greater if the L/C is made payable in a country with lower interest rates. Where the Banker’s Acceptance Rate might be 11% in Hong Kong, it might be 6.1% here or, even better, in Japan where the rate might be 1 or 2%.

Doing Business without a Substantial Balance Sheet

Back-to-Back Letters of Credit

How to do business on someone else’s balance sheet

On the strength of a L/C you receive you can ask your bank to issue a L/C for you

Unfortunately, most American banks don’t like to do this; they think this is the equivalent of a credit commitment.


A Transferable L/C

Banks prefer this method today.Banks prefer this method today.

If the L/C you receive is “transferable,” then you If the L/C you receive is “transferable,” then you can ask your bank to “transfer” the L/C to your can ask your bank to “transfer” the L/C to your supplier. supplier.

In doing this the bank can change two things: In doing this the bank can change two things: the dollar amount the dollar amount andand the termination date. the termination date. – This way you can get your “mark-up.”This way you can get your “mark-up.”


Assignment of Proceeds

In this case, your bank issues your supplier an “Assignment of proceeds” for the amount of money you owe to your supplier; when the bank collects on the LC, it transfers the amount due to your supplier.

This is tough to do in developing countries, e.g., China, as they are not familiar with this.

Clean Letters of Clean Letters of CreditCredit

Means “clean” of documentation, i.e.., no merchandise.

Two basic purposes– To make payments– For “guarantees”

Examples of Clean L/C … Used as a “Guarantee”

In lieu of bonding for project finance– For Performance … Bond normally

cheaper

To guarantee notes or bonds

When using clean L/Cs as “guarantees,” what you are really doing is changing the “apparent risk”.

Costs of L/Cs

Issuing Bank charges about $25 to $100 for writing the letter plus a percentage of the dollar amount, for example, 3/8ths% to 1.5%.– The % can vary substantially– Big difference between US and European Banks– Also charges for amendments

Advising Bank also imposes charges

Using L/Cs with a revolving line of credit

Be Careful!

Customer might ship when you don’t want him/her to ship.

In addition to In addition to L/Cs:L/Cs:

Banks can provide a collection service

Documents on Payment (DP)

Documents on Approval (DA)

LETTERS OF CREDIT

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Economy & Finance

Letters Of Credit