Letter of Credit — Types & Operations
Relevent for JAIIB PPB | CAIIB ABM | CCP Module C
Why It Matters in Branch:
LC is the most common non-fund based facility in trade finance. Every bank officer in credit or trade finance department handles LCs daily.
SHORT NOTES
DEFINITION:
A Letter of Credit (LC) is a written commitment by the Buyer’s Bank (Issuing Bank) to the Seller, promising to pay a specified amount provided the Seller submits documents strictly conforming to the LC terms within the specified period.
PARTIES TO LC:
1. Applicant (Buyer/Importer) — who applies to his bank to open LC
2. Issuing Bank — Buyer’s bank that opens/issues the LC
3. Beneficiary (Seller/Exporter) — who receives the LC and ships goods
4. Advising Bank — Seller’s local bank that advises (communicates) the LC to seller
5. Confirming Bank — Bank that adds its guarantee to the LC (optional)
6. Negotiating Bank — Bank that purchases/negotiates documents from seller
TYPES OF LC:
1. Revocable LC — Can be cancelled by issuing bank without notice. Almost never used in practice. UCP 600 does not recognise it as an LC.
2. Irrevocable LC — Cannot be cancelled without beneficiary’s consent. Standard in practice.
3. Confirmed LC — Additional guarantee added by another bank (usually in seller’s country).
4. Standby LC — Functions like a Bank Guarantee. Payment on default, not on presentation of trade documents.
5. Revolving LC — Automatically reinstates after utilisation. For regular suppliers.
6. Red Clause LC — Pre-shipment advance allowed to beneficiary before shipment.
7. Green Clause LC — Pre-shipment advance with warehouse receipt required.
8. Back-to-Back LC — Secondary LC opened using original LC as security. Used by intermediary traders.
9. Transferable LC — Beneficiary can transfer LC to another party (second beneficiary).
10. Deferred Payment LC — Payment made after a fixed period from date of shipment (usance LC).
GOVERNING RULES:
UCP 600 (Uniform Customs and Practice for Documentary Credits) — issued by International Chamber of Commerce. All LCs must state they are subject to UCP 600.
DOCUMENTS UNDER LC:
Commercial Invoice, Bill of Lading/Airway Bill, Packing List, Insurance Certificate, Certificate of Origin, Inspection Certificate.
KEY PRINCIPLE: Banks deal in documents, NOT in goods. If documents strictly conform to LC terms, bank must pay — even if goods are defective.
BRANCH CONTEXT
✦ The most expensive mistake in LC handling is payment against discrepant documents without proper authorisation. If a buyer refuses to accept discrepant documents and the bank has already paid, the bank is stuck with the liability. Every document scrutiny under LC must be precise — quantity, description, date, port — exactly as per LC terms.
