What is a letter of credit and how it is opened

LETTER OF CREDIT :-
Mr. Frank Henious has defined it in the following words, "The letter of credit is a written instrument issued by the buyers bank authorizing the seller to draw in accordance with certain terms and conditions."

According To Pritichard, "The letter of credit is commitment on the part of the buyers bank to pay or accept drafts drawn upon it provided such drafts do not exceed a specified amount."
According to the above definitions there are four parties, involved in this letter.


HOW A LETTER OF CREDIT IS OPENED :-

1. Importer :-
The person who purchases the goods from other country. He requests for the letter of credit to the bank. He may be called buyer.

2. Exporter :-
He is the person in whose favour the letter of credit is opened. He is called seller or exporter.

3. Opening Bank :-
It is the bank which issues the letter of credit. It is also called the issuing bank.

4. Paying Bank :-
The bank which makes the payment to the exporter after receiving the letter of credit is called paying bank.


OPENING OF LETTER OF CREDIT :-
International trade is financed through the letter of credit, which is quiet simple.
Following is the procedure of issuing a letter of credit :

1. Sales Contract :-
If exporter of any country agrees to sell any particular commodity to the importer of the other country. They will do an agreement.

2. Documents Preparation :-
Now they will prepare the contract documents. Importer will get performa and will provide all the particulars of contract in the performa.

3. Contact With The Bank :-
The importer will contact with the bank and will provide all the documents regarding the agreement and will request for the letter of credit.

4. Application Form :-
The bank will provide an application form if it finds that documents are correct. The importer will submit application form with necessary details disclosed between the importer and exporter like shipment insurance and total value of goods. The applicant will request to open an L.C in favor of exporters.

5. Undertaking From Importer :-
The opening bank obtains an undertaking from the applicant that he will purchase the documents from the bank at the "Markup" price fixed by the State Bank.

6. Margin Requirements :-
If the goods are imported according to the margin requirements, then importer will be asked to deposit the same amount. The margin requirements generally very from 10 to 25% of the total amount for which the L.C is opened. It is refundable amount.

7. Issuance Of L.C :-
The bank writes the L.C after the completion of formalities. It is in a printed for form. The bank prepares its four copies and these are distributed among the four parties.

8. Dispatch And Confirmation Of The L.C :-
The application may be dispatched in the first place by telecommunication and then confirmed in writing by sending the original L.C. Now we can explain it further by the following example :

Example : Suppose Indian importer got the L.C in favor of U.S.A exporter in New York, authorizing him to draw sight draft. The bank will transit the L.C to exporter through bank in New York.

9. Obtaining Of Documents And Shipment :-
Exporter will send the goods by ship and will get the receipt from the shipping and insurance company. He will complete all the documents mentioned in L.C.

10. Submission Of Draft And Documents :-
The exporter will submit his bill and other documents to the bank in New York.

11. Payment :-
The paying bank will examine all the documents according the terms and conditions mentioned in the letter of credit. and will forward all the documents to the opening bank In India.


NOTE :-  In some countries interest free banking system is working. So the negotiation of the documents by the negotiating bank means the sale of the same by the importer to the issuing bank for the amount  of the draft plus all the charges of banks. Moreover, it means that the importer has simultaneously bought back from the bank the said documents at the aforesaid sale price plus markup on the net amount less then amount of margin.