LETTERS OF CREDIT Chapter 12

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LETTERS OF CREDITChapter 12
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WHAT IS A LETTER OF CREDIT?

• SIMPLY STATED
• A LETTER OF CREDIT IS A LETTER FROM ONE BANK
  TO ANOTHER INSTRUCTING THE SECOND BANK TO DO
  SOMETHING for a fee.

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LETTERS OF CREDIT

• Banks do NOT have to issue letters of credit
  they do so as an accommodation to their
  customers. Even though banks charge for their
  service, they are doing the business a favor.
• Getting an L/C is great.
• Giving an L/C may be painful

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TWO BASIC TYPES OF LETTERS OF CREDIT

• International
• Generally more flexible and less costly
• Especially if drawn on a bank outside of the US
• Must deal with Currency Issues!!!
• Domestic
• Some limitations due to US banking laws
• Not used very extensively
• Generally take money from Buyers account when
  opened!

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DICOTOMIZING L/Cs

• Revocable L/Cs
• Can Be Terminated at Will or by the Occurrence of
  Some Event
• Irrevocable L/Cs
• Can Not Be Terminated by the issuing party.
• Most are Irrevocable!

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DICOTOMIZING L/Cs

• Documented L/Cs
• Means That Merchandise is Involved
• Inspection Certificate, etc. (3rd Party)
• Clean Letters of Credit
• Means Clean of Documentation- no merchandise
  involved.

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DICOTOMIZING L/Cs

• Confirmed L/C
• Means that a Local Bank has the Authority to pay
  on the L/C.
• Non-Confirmed L/C
• Means that the Local Bank must send the paperwork
  to the originating country for approval and only
  after that approval is given will the local bank
  pay on the L/C.
• Beware in Developing Countries!!

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DICOTOMIZING L/Cs

• Actual L/C
• One on which money will be paid if the proper
  documentation existsNo Ifs.
• Stand-by L/Cs
• Substituting your banks balance sheet for your
  (possibly anemic) balance sheet. Bank does not
  expect to pay on this.

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General Features of an L/C

• Buyer/Writer Seller/Beneficiary
• Issuing Bank Advising Bank
• Amount Which Currency
• of Purchase Price
• At Sight Deferred payment
• Partial Shipment?
• Transfer of Title FOB, CIF, CF, etc.
• Documents i.e. Inspection Certificate
• Remember banks pay only on paperwork!!
• Special Instructions i.e. latest shipment date,
  who pays for amendments, etc.

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An International L/C Example/Tricks

• An American wants to buy from a firm in Hong
  Kong.
• How would he/she pay for the merchandise?
• Send the seller an L/C, payable, say, in 60 days.

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If the Holder of an L/C that is not payable on
Sight wants his/her money now, he or she can
discount the draft at the Bankers Acceptance
Rate. The Bank can keep the discounted note or
endorse it and sell it in the money market.
An International L/C Example/Tricks
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An International L/C Example/Tricks

• Whats Beautiful About That?
• The Bankers Acceptance Rate might be two points
  below Prime. This is instead of financing
  Receivables at, say, two points above Prime. A
  swing of, perhaps, four points.

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An International L/C Example/Tricks

• and the interest saving can be even greater if
  the L/C is made payable in a country with lower
  interest rates. Where the Bankers Acceptance
  Rate might be 11 in Hong Kong, it might be 6.1
  here or, even better, in Japan where the rate
  might be 1 or 2.

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Doing Business without a Substantial Balance Sheet

• Back-to-Back Letters of Credit
• How to do business on someone elses balance
  sheet
• On the strength of a L/C you receive you can ask
  your bank to issue a L/C for you
• Unfortunately, most American banks dont like to
  do this they think this is the equivalent of a
  credit commitment.

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Doing Business without a Substantial Balance Sheet

• A Transferable L/C
• Banks prefer this method today.
• If the L/C you receive is transferable, then
  you can ask your bank to transfer the L/C to
  your supplier.
• In doing this the bank can change two things the
  dollar amount and the termination date.
• This way you can get your mark-up.

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Doing Business without a Substantial Balance Sheet

• Assignment of Proceeds
• In this case, your bank issues your supplier an
  Assignment of proceeds for the amount of money
  you owe to your supplier when the bank collects
  on the LC, it transfers the amount due to your
  supplier.
• This is tough to do in developing countries,
  e.g., China, as they are not familiar with this.

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Clean Letters of Credit

• Means clean of documentation, i.e.., no
  merchandise.
• Two basic purposes
• To make payments
• For guarantees

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Examples of Clean L/C Used as a Guarantee

• In lieu of bonding for project finance
• For Performance Bond normally cheaper
• To guarantee notes or bonds
• When using clean L/Cs as guarantees, what you
  are really doing is changing the apparent risk.

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Costs of L/Cs

• Issuing Bank charges about 25 to 100 for
  writing the letter plus a percentage of the
  dollar amount, for example, 3/8ths to 1.5.
• The can vary substantially
• Big difference between US and European Banks
• Also charges for amendments
• Advising Bank also imposes charges

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Using L/Cs with a revolving line of credit

• Be Careful!
• Customer might ship when you dont want him/her
  to ship.

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In addition to L/Cs

• Banks can provide a collection service
• Documents on Payment (DP)
• Documents on Approval (DA)

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LETTERS OF CREDIT

• END