Letter of Credit
AdvancedA letter of credit is a written commitment by a bank, made on behalf of a buyer, to pay a seller a specified amount once the seller presents documents showing it has met the agreed conditions, such as shipping the goods.
Letters of credit are widely used in international trade, where buyers and sellers may not know or trust each other. The bank's promise replaces the buyer's promise, reducing the seller's risk of not being paid.
The process typically works like this. The buyer asks its bank to issue a letter of credit in favour of the seller. The seller ships the goods and presents the required documents, such as a bill of lading, invoice and inspection certificate. If the documents comply exactly with the terms, the bank pays the seller, then collects from the buyer.
For example, a clothing importer in the United Kingdom buying 200,000 worth of garments from a manufacturer in Bangladesh might arrange a letter of credit, so the manufacturer is confident of payment once it ships.
Banks deal only with documents, not the goods themselves, so the documents must be precise. International rules published by the International Chamber of Commerce govern most letters of credit. A standby letter of credit acts more like a guarantee, paying only if the buyer fails to pay.
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