How Letter of Credit Works | Functioning of A Letter of Credit

by Alex Pardin Financial Consultant

A letter of credit is a letter that is issued by a bank to another bank. It is basically issued by the bank of importer to the bank of exporter as a guarantee of payment of certain amount at correct time. It is mainly used in international trade.

One of the most important and useful function of a letter of credit is that they provide buyer’s protection as well as seller’s protection. If one pays the seller for the product or service that they have failed to deliver, then one might get paid using a standby letter of credit. That payment will be an obligation on the company that was not able to provide the product or the service. This is how a letter of credit serves buyers protection. And if a buyer fails to make the payment to the seller, then the bank that issued the letter of credit will pay to the seller only when the seller meets all the requirements of the letter. This is how it provides security to the seller too.

Sometimes a Letter of credit is used in few domestic transactions too such as construction project.

Some important things about a letter of credit

A letter of credit provides security for sellers as well as buyers.
A letter of credit gets issued by the bank only when a “business” asks for it and has some assets or credit to get the approval.
A Letter of credit is difficult and it is very easy to make an expensive mistake while employing it.

Source of money for a letter of credit

It has been mentioned above that that the bank promises a payment on behalf of a client. But did you wonder from where this money comes?

A bank issues a letter of credit only if the bank finds paying potential in the buyer or importer. The bank makes some buyers to pay the bank up front or permit the bank congeal funds held at the bank. A line of credit is used by others to get a loan from the bank.

Sellers should have faith in bank that the bank issuing the letter of credit is legal and will pay as agreed. But if the sellers or exporters have any doubt or confusion in this regard; then can ask for a “confirmed” letter of credit. A “confirmed” letter of credit means that if the bank issuing the letter of credit fails to make the payment, then in this “confirmed” letter of credit another bank guarantees the payment. A “confirmed” letter of credit is supposed to be more trustworthy and confident.

Exporters or sellers usually get a letter of credit issued by the bank in their home country only.

How does the payment is made?

The holder of a letter of credit is paid only after carrying out some desired moves and meeting the needs and requirements mentioned in the letter of credit.

For International Trade: The exporter has to deliver goods to shipping port to meet the requirements of the letter of credit. The exporter gets some documents only after delivering the goods, the documents received by the exporter confirms that the delivery has been made and then the documents are sent to the bank. In some cases, the letter of credit has to be paid at the time of delivery only, it doesn’t matter what happens to the merchandise afterwards.

Documents required: The bank only analyze the documents proving that the exporter has performed all the actions and has met all the requirements of the letter of credit in order to sanction payment on a letter of credit.

The bank doesn’t care about the quality of the goods or other necessities of the importer. But exporter is not allowed to ship malfunctioned goods; in such cases the importer can ask for an inspection certificate. This certificate allows an official to examine shipment and ensure the importer about the quality.

A “Performance” transaction: To receive a payment on the basis of a standby letter of credit, the holder of the letter of credit might have to prove that the other person has done something wrong. In such cases, the bank will pay to the one who has suffered.

Business banking services in Malaysia

There is easy, quick and transparent banking with Standard Chartered Business Banking provided by some banks in Malaysia. These services help you in enhancing your growth, making business banking simple, protecting your business, taking your business across borders, and providing the right support.

Business banking services include Business installment loans, commercial mortgage loans, business working capital, and letter of credit services.

Letter of a credit Malaysia

In Malaysia, Some banks issue LC under Murabaha Contract. A letter of credit is issued on request as a buyer/applicant to pay the seller/beneficiary a certain amount. The merchandise purchased will be sold at a marked up price for a deferred payment. On the other hand, on the negotiation of the LC one might has to pay the negotiation amount at the cost.