Letter Of Credit

MECHANISM IN LETTER OF CREDIT

While dealing by an individual or entity in different countries, both seller and buyer do
not have confidence on each other. Buyer would insist delivery of goods first and would
like to pay after receipt of goods. But Seller on the other side would like to act on the
contrary; he would like to receive funds first and then would like to send the goods.
So in this situation there would not be any trade.
Since bank enjoys a repute of trust and confidence, so it acts as guarantor to both seller
and buyer.
It provides guarantee to seller that in case the goods are shipped to the buyer, he would
definitely get the value of goods. Similarly the buyer would be guaranteed that he would
get the goods according to the worth of his money.
This bridge of confidence is built by at least two bankers, i.e. banker of seller and
banker of buyer, and this trust are managed by way of an instrument known as Letter
Of Credit. And no doubt for providing such facility, both bankers earn by way of charges
those are either borne by buyer, seller or both of them as agreed mutually between
buyer and seller.
COMMENTARY ON SKETCH FOR MECHANISM OF A LETTER OF CREDIT.
Buyer directly contacts with the seller to know about the cost of merchandise; buyer
intends to buy. It is known as enquiry.
Seller would offer the rates of the goods and other terms.
If those rates and terms are agreed by both of them, they enter into a written
agreement.
On the basis of that agreement buyer requests his bank to send a letter on his behalf
to the seller to dispatch as per agreement. That agreement contains name, brand,
colour , model, size, number of items, rates, mode of transportation; indicating who
would bear the cost of transportation and Insurance premium amount, validity of offer
and approximate date/period of shipment of goods.
Bank sends a letter addressed to the seller (Not The Bank Abroad), requesting seller
to dispatch goods as per terms of this letter, and after shipment submit set(s) of
documents, having proof of shipment of goods to a bank; nominated by the buyers
bank. The most important document is Document Title to Goods like Airway Bill, Bill of
Lading. Railway Receipt and Post Parcel Receipt etc. The document depends upon the
mode of transportation agreed between buyer and seller and it is specifically contained
in the letter. This letter is known as Letter of Credit.
A copy of this letter is mailed to foreign bank, which would accept documents from

seller.
No doubt that the letter is addressed to the seller, but it is not mailed to the seller
directly, but through the bank abroad, and buyers bank request the sellers bank to
hand over this letter to the seller.
Why not to dispatch to seller directly.
This letter specifically guarantee/undertake to make the payment to the seller
immediately after shipment or on future fixed date if agreement is to pay on usance
basis.
Now seller is confident that he would surely get the payment for the goods he would
be selling some one abroad, and with whom he has no other relations and even not
knowing buyer otherwise.
Seller would dispatch the goods, would prepare set(s) of documents mentioned in
letter of credit and would submit to the bank abroad. That bank after thorough scrutiny
would debit the account of buyers bank (if value of letter of credit is stated in the
currency of sellers bank) or if the currency is alien currency to that bank than that
sellers bank would claim the amount from other bank on behalf of buyers bank and it
would be paid, as in this a copy of this letter of credit is also mailed to that third bank;
authorizing that bank to honour the claim of sellers bank.
(THIS POINT IS TO BE ELABORATED MORE IN SESSION)
Sellers bank after making payment to the seller would dispatch documents to the bank
of buyer.
At this point one end of the guarantee is settled as the seller got his value for the goods
he sold.
Now the goods are coming to the country of buyer; through Air Craft or Ship and
simultaneously the documents are also traveling from the country of seller to the country
of buyer.
The goods have been shipped in favour of buyers bank and only that bank is entitled
to get the goods released from the carrier or by a nominee of buyers bank. Reason
being the buyers bank has made the payment to the seller and this value is yet to be
received from the buyer.
On receipt of documents the buyers bank would intimate the buyer and would
request buyer to come and collect documents; after making payment in local currency.
As discussed in class that in Pakistan when goods are imported our importer makes
payment in Local currency, where as the buyers bank account was debited in foreign
currency. It indicates that the bank has made payment on behalf of buyer and this
payment would be termed as Sale of Foreign Currency to the buyer.
Later on buyer would come and would authorize its bank to debit his account and
hand over the documents, and to remind you these are the documents on the basis of
those the seller received the value of his goods, and now when the these are being
handed over to the buyer; bank would get its money.
As already stated that Goods were shipped in the favour of buyers bank and only that
bank or its nominee is entitled to get the goods released. So after receiving money from
buyer, the buyers bank would authorize the buyer to get the goods cleared and take its
delivery. This process of transferring the title of goods is done through endorsement.
Now the final end of the guarantee is also settled as the buyer would get the goods

against the value he paid.

This transaction was only possible through an undertaking given by the bank and is
called Letter of Credit
BANKING TERMINOLOGIES FOR ABOVE STATED DEALING
Until now we have been using layman/easy language just to make the students
understand effortlessly. But we being heading toward getting expertise in International
Banking, we must be acquainted with real Banking terms and those are:Document which serves the purpose of
offer from beneficiary, in which description
of goods, with price, brand colour, model
and other terms are stated, signed by the
exporter, and later on when importer accepts it
by signing on its face and submits to the
opening bank as an agreement for establishment
of letter of credit. Performa Invoice
Buyer Importer/Opener of L/c
Seller. Exporter/Beneficiary
Buyers Bank Opening Bank.
Sellers Bank through whom L/c was sent. Advising Bank
Sellers Bank when making payment to seller. Negotiation Bank
The bank from which negotiating bank
claim reimbursement in case of other currency
known as third bank Reimbursing Bank
Process whereby negotiating bank checks
documents in terms of L/c before making
payment To exporter Negotiation

Finally we must know What is a Letter of Credit ?

It is an instrument in shape of a letter issued on behalf of the opener, by opening bank;

addressed to the beneficiary, having an undertaking that he would get the value of
goods shipped by him, but strictly in terms of letter of Credit.
OTHER RELATED TERMINOLOGIES
FOB Free on board
C&F Cost and Freight
CIF Cost Insurance and Freight