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LETTERS OF CREDIT - CONCEPTS

PROF. MURALI KRISHNAMURTHY

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Letter of Credit

• Suppose a buyer in Mumbai, has placed an order for supply of certain goods, with a supplier in
Chennai. The supplier is not willing to part with the goods unless he is assured that he will get his
payment. And the buyer would not pay for the goods until he receives the goods.

• To overcome this stalemate, the bank acts as an intermediary, and opens a Letter of Credit favouring
the supplier.

• A Letter of Credit is an arrangement whereby, a bank agrees to make the payment on behalf of the
buyer to the supplier, upon receipt of certain documents, provided that the terms and conditions as
specified in the Letter of Credit are satisfied. The supplier of the goods would be the beneficiary in
the Letter of Credit.

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Letter of Credit

• Letter of Credit is opened by a bank only on behalf of its own customers.

• Bank ensures that the LC amount is within the available credit limit for the Customer

• LC is prepared in a standard specified format and sent to the beneficiary.

• LC document includes the details like Value of LC, Type of LC, Beneficiary Details, Goods and Shipment
details.

• Commission, Postage, Commitment Charges and Margin on the Letter of Credit amount are debited
from the customer’s Current or CC/OD account, and credited to the corresponding Income accounts.

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Goods MTR

Beneficiary MTR Goods

Applicant

Life Cycle of an
LC MTR Payment LC Request to
Issue LC MTR Payment

LC

MTR

Payment

Negotiating
Advising Bank
Bank Issuing Bank
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LC Issue & Related Functions

• Issue LC.
• Receive Acknowledgement to LC.
• Lodgment of Bills under LC.
• Register Acceptance (For Usance Bills)
• Payment of Bills under LC.
• Expire LC

This is the Happy Path…….smooth flow….no complications.

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LC Issue
Receives application from
applicant

Issue LC – Copying Register LC (Assign Issue LC one step


Existing LC Temporary Ref. Number)

Issue LC after Register


(Assign LC Ref. Number)

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Payment of Inland Bills Under LC

• The documents are released to the customer on making full payment of


the bill in the case of Sight Bill

• In case of insufficient balance in the customer account, the bill amount


will EITHER be debited to Overdue account and recovered later with
Interest OR debited to the Customer account with higher official’s
Authorization

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Other Functions
• Other functions Required to deal with complexities of trade finance are :

Amend LC Update Bill Discrepancies

Claim Charges from Applicant Refuse Documents

Close LC. Reset Discrepancy Flag

Manual Release of Margins Amendment/Discharge of LC Bills

Tracers for Acceptance of Bills

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Update Discrepancies
Example:
Consider documents under LC have following discrepancies:
Late Shipment
Stale Bill of Lading
LC Expired

Assume the applicant accepts first discrepancy of Late Shipment.

In core banking a special function is used to update the discrepancy status of this discrepancy and
inform the same to remitting bank, if required.

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LC Advising & Related Issues
• Inland LC Advising.

• Registration of Bills under LC.

• Negotiation of Bills under LC.

• Payment of Outward Bills under LC.

• Inland Outward LC Expiry.

This is the Happy Path…….smooth flow….no complications.

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Inland LC Advising
• Buyer’s bank issue the LC favoring seller and sends the LC to its branch or correspondent.

• The Advising Bank receives LC from Issuing Bank either via SFMS or via Telex/ Mail/ Fax.

• After checking the authenticity of the LC, bank decides the acceptability / workability of LC.

• The advising bank can advise the LC to the seller directly. In case there is an instruction to advise
through a bank mentioned in the LC, will advise the LC to the seller through that bank

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Inland LC Advising

• If the advising bank expresses its inability to advise the LC to the seller, it must inform the Issuing
Bank without delay.

• If the LC calls for confirmation of LC, then upon checking for bank risks, it may confirm the LC. (The
necessary accounting entries will be passed for control).

• If the advising bank expresses its inability to confirm the LC to the seller, it must inform the Issuing
Bank without delay.

• The bank may recover the charges at advising stage or later if he is a customer of the bank.

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Confirmation of LC

• In our previous example, the bank in Chennai may not agree to discount an LC issued by a certain
regional bank in Mumbai, and may insist that the LC is also confirmed by an acceptable bank in South.
In such a case a bank in Chennai may add its confirmation to the letter of credit.

• In the event of the Purchaser not being able to pay for the goods, under the terms of the Letter of
Credit, the bank in Mumbai will be liable to pay the supplier. In case a bank in Chennai has confirmed
the Letter of Credit, then even that bank is liable to pay the supplier in case the bank in Mumbai is not
able to pay.

• The bank in Chennai is called the Confirming Bank.

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Negotiation of Bills under LC
• After verifying the Bill Discounting Limit for customer, Bill is registered in the system.

• If Reimbursing Bank is involved in the transaction, reimbursement is claimed at the time of the transaction in case
of Sight bills and on maturity date in case of Usance bill.

• Because of Beneficiary’s request, or unavailability of discounting limits or Bank not wanting to negotiate for the
full amount, Bill may be negotiated for partial amount.

• The Bank applies and recovers Interest upfront from the Date of Negotiation till the Maturity date.

• Based on above interest and other charges ‘Net Amount to Beneficiary’ will be calculated.

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Conversion of Collection Bills to Negotiation Bills

• This function is generally invoked in following two cases:


• An outward Bill under LC is drawn by the drawer but with discrepancies. The beneficiary’s Bank sends such
discrepant bills to the drawee. In the case of such bills being accepted with discrepancies, the beneficiary’s
bank can now negotiate/discount the bill and credit the proceeds to the customer’s account.
• The beneficiary draws an outward bill under LC. The beneficiary’s bank is not in a position to
discount/negotiate the bill since the beneficiary has exhausted his limit for discounting of bills. In such a case
the Bill is sent on collection basis to the applicant and when the limit for discounting becomes available for the
beneficiary, the bill is negotiated/discounted.

• Bills are identified by the bank on the basis of the reference number allotted at the time of sending the bills on
collection and the same reference number is used to negotiate/discount the Bill.

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Reversal of Overdue Outward Bills

• This function is used for reversal of outward bill when the bill remains unpaid beyond
the due date for x (parameter) number of days after due date.

• This function is also used in cases where the outward bill discounted/negotiated is
returned unpaid, in which case the recovery has to be done immediately without
waiting for the due date.

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Import

• Imports can include


• Capital Goods such as machinery
• Raw materials used in manufacture

• Banks facilitate imports by establishing LCs or by making Advance


Payments
• LCs issued are usually linked to a either a Term Loan or Cash Credit
Account

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General Flow of Imports
• Importer approaches his bank to issue a LC for a particular amount and particular
currency
• Issuing Bank may decide to issue LC subject to the conditions
• Issuing Bank then advices to Advising Bank about the LC which is subsequently
conveyed to the Beneficiary / Exporter
• Beneficiary submits the documents to the Advising Bank which are then forwarded to
the issuing Bank
• Issuing Bank verifies if the received documents are as per the terms and conditions
(specified in the LC)

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General Flow of Imports (Contd)
• In case the documents are as per the terms & do not have discrepancy and it is a sight bill, it will
be delivered to the importer on Payment
• In case the documents do not have discrepancy (documents are as per the terms) and it is a
Usance bill, it will be delivered to the Importer after acceptance
• In case the documents have discrepancy (for both Usance and Sight Bills ), the discrepancies
should be accepted by both the importer and Issuing Bank. On acceptance, of discrepancies, the
documents are considered as without discrepancies and they follow a normal course as above
• In case the discrepant documents are refused by either importer or the issuing bank, they will be
sent back to the Negotiating/ Remitting bank

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General Flow of Import Bills under LC (Contd)
• On the Bill Maturity Date, reminder / tracer is sent to the importer for payment

• In case importer responds to tracers, the bill will be paid as per the direction of importer.

• In case there is no balance in the importer’s account on due date, the bill amount is either
debited to his account, in spite of insufficient balance/ limit with higher Authorization
level or debited to an Overdue account and recovered with Interest at a later date

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Bills payment under LC

Buyer Transporter Seller

Issuing Importer
BankIssuingapproaches
Bank may his
decide
bank totoBank
issue
issueabout
LC
a LC for a
Sight Bills: then advices
Documents to Advising
are delivered against Payment
the LC particular
subject
which is amount
to the and
subsequently conditions
particular
conveyed currency
to the
Advising Usance
Exporter
Transport
Importer
Bank Bills:
submits
agency
Transport
Exporter
submits
the
forwards Documents
delivers
Document
documents
despatches
Bill
the goodsare
of Entry
is
documentsto
and
thedelivered
submitted
Advising
togoods
Bill
the
to of
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Issuing the
bank Transport
Beneficiary
Acceptance/ Exporter
agency

Advising Bank Negotiation Bank


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LC Amendment

• The applicant instructs his bank (the Issuing Bank) to amend the LC.
• The bank ensures that the terms and conditions of the credit are precise, complete and in
accordance with the sales contract.
• LC amendment information is mailed to advising bank.
• Examples of detrimental amendments are LC Amount is decreased / Currency is changed/
Decrease in Validity period. Other Amendments are treated as Non Detrimental.
• Beneficiary’s consent is needed for Detrimental changes
• Non discrepant documents can be given to importer in case of acceptance

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Process Flow of Amendment

Receives application
for amendment

LC is amended

Send advice to
Advising Bank
Import Bills

Import Bills can be broadly classified into:

• Import Bills under LC

• Import Collection Bills

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Import Bill Lodgment under LC
• In import Bill Lodgement under LC, all details of the documents received with Import bill,
under the relevant LC are captured

• After bill lodgement under LC, the LC Balance is to the extent of the Bill Amount

• Acknowledgement of the receipt of the documents is sent to the foreign bank

• After Bill lodgement under LC, the bank sends an advice to the Applicant for:
• Acceptance in case of Usance Bills and
• Payment in case of Sight Bills

• In case of discrepant documents, the discrepancies are to be accepted by the importer and
then by the bank.

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• Bill Lodgment can be
• After Early Reimbursement (in case of Sight Bills with Reimbursement Clause)
• In case of Early Reimbursement, the Negotiation bank claims the Reimbursement immediately
on sending the documents.
• Reimbursement bank debits the Issuing bank’s Nostro and make payment to Negotiation bank
• Hence in this case, the bill is paid/ reimbursement even before the receipt of the documents
• Issuing bank first registers the Early reimbursement made
• Then on receipt of documents records the bill details
• On payment of the bill by the Importer, the bank recovers the interest from the date of debit in
Nostro to the date of payment

• Bill Lodgment in the normal way after receipt of documents

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Import Bill Payment

• Customer can make payment of import bill in different ways as follows:


• Delivery of Forward Contracts
• Disbursal of PCFC
• Debit to EEFC
• Conversion using Online/ Card Rate

• The documents are released to the customer on making full payment of the bill in case of Sight
Bills and after acceptance in case of Usance Bills
• ( System Check - Import Bills entered will be due for payment in case maturity date <=
system date)

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Close LC
• Close LC involves closure of an LC before it’s expiry

• This is done in case the LC transaction has not come to normal end.

• If there are any Outstanding charges, they will be recovered

• The LC record is set to Close. No Further Transactions can be done on a closed LC

• Reversal of Control entries for outstanding balance & recovery of outstanding charges
will be generated

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