LETTER OF CREDIT
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LETTER OF CREDIT
/DOCUMENTARY CREDIT
Letter of Credit is an undertaking issued by a
Bank (Issuing Bank), on behalf of the buyer
(the importer), to the seller (exporter) to pay
for goods and services provided that the seller
presents documents which comply with the
terms and conditions of the Letter of Credit
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LETTER OF CREDIT
UCPDC – 600 Edition effective from 1st
July 2007
Documentary
Credit
means
any
arrangement that is irrevocable and thereby
constitutes a definite undertaking of the
issuing bank to honour a complying
presentation.
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Complying presentation
a presentation that is in accordance with
• the terms and conditions of the credit,
• the applicable provisions of these rules (UCP 600) and
• international standard banking practice.
Honour
a. to pay at sight if the credit is available by sight payment.
b. to incur a deferred payment undertaking and pay at maturity if
the credit is available by deferred payment.
c. to accept a bill of exchange ("draft") drawn by the beneficiary
and pay at maturity if the credit is available by acceptance.
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LETTER OF CREDIT
• Three main contracts underlying LC
- Sale Contract between Buyer & Seller
- Application-cum-Guarantee between
Applicant(Buyer) and Issuing Bank
- LC itself (contract between Issuing
Bank and Beneficiary/Seller)
( LC independent of other two contracts)
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Mechanics of Documentary Credit
CONTRACT
IMPORTER
GOODS
GOODS
DOCS
DOCS
EXPORTER
Letter of
Credit
Advising bank
DOCUMENTS
DOCUMENTS
PAYMENT
Reimbursing Bank
Negotiating Bank/
Confirming Bank
PAYMENT
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Parties to Letter of Credit
•
•
•
•
•
•
•
Opener/Buyer
Issuing Bank
Advising Bank
Beneficiary/Seller
Nominated Bank/Negotiating Bank
Confirming Bank
Reimbursing Bank
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Types of credit
Security to beneficiary

Confirmed
 Mode of settlement



Payment/ deferred payment
Acceptance
Negotiation
Involving middlemen


Transferable
Back to back
Involving advances


Red Clause Credit
Green Clause Credit
Involving repeated transactions


Revolving
Stand by
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Transferable Credits
• Credit has to be opened as transferable
• The beneficiary is normally a trader or agent
• He transfers credit to his supplier - second beneficiary.
• Transferred by a bank at the request of first beneficiary
• Second beneficiary can supply goods and negotiate documents as
if he had received the credit.
• He may pay commission to first beneficiary for the order
• There can be more than one second beneficiary.
• No third beneficiary is permitted.
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Transferable Credits
• The following parameters may be changed while
transferring a credit
– Amount of credit, unit price and quantity of goods
– Date of expiry, last date of shipment and last date of
negotiation can be brought forward
– % of insurance cover may be increased.
• First beneficiary has the right to substitute documents
negotiated by second beneficiary.
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Back to Back Credits
• Exporter receives a credit from his buyer ( Selling credit)
• He has to procure goods from other suppliers
• He opens a credit for purchase of the goods ( buying credit)
• Second credit is said to be back to back to the first one.
• Bill proceeds of the export LC (Selling LC) will be used to meet
liabilities under the second (Buying LC)
• Amount of back to back credit will be lower.
• Usance period of the back to back credit should be equal to or more
than that of the export credit.
• Bank still at risk if the customer fails to export
• No concession in margin and security norms.
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Revolving Credits
• Credit is opened to cover a series of regular transactions over a
longer period
• Beneficiary will submit a series of documents
• Maximum value of each document will be fixed and is the
revolving limit
• LC amount is the maximum value of documents that can be
handled under the credit.
• The credit may be reinstated automatically or after payment of
earlier bill.
• It can be opened as cumulative or non cumulative.
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Standby Letters of Credit
• Credit is issued for a particular amount and for a particular period
• Trade takes place on running account basis.
• Beneficiary does not submit documents to bank.
• If there is a default, he can claim funds from opening bank giving
a certificate of default
• No quibbling over discrepancies and documents
• Opening bank will pay on demand
• Works like a bank guarantee
• UCPDC is applicable if so declared in the credit
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LC Regulations
•
•
•
•
Foreign Trade Policy requirements.
FEMA requirements.
Credit norms of Central Bank.
UCPDC 600 Provisions.
• Bank’s Internal Credit Policies/ procedures.
• Public notices issued by DGFT
• Uniform
Rules
for
bank-to-bank
reimbursements 525
• Incoterms 2010
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Bank’s Obligation & Responsibilities
• Issuing Bank (opening bank)
( UCP Article 7)
-the prime obligator
-to ensure credit-worthiness and trust-worthiness
of the applicant
- Once credit is opened, the bank is placing itself
as a substitute for the buyer.
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Bank’s Obligation & Responsibilities
• Advising Bank has the obligation to
authenticate the credit once it is received
and passing it promptly on to the beneficiary
( Art.9).
• Confirming
Bank
takes
over
the
responsibilities of the issuing bank as far as
the beneficiary is concerned though it has
got recourse to the Issuing Bank (Art 8).
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Bank’s Obligation & Responsibilities
Negotiating Bank
• to examine docs. Within 5 banking days
after receipt of the documents at their
counters(Art 14b).
• to ensure compliance of credit terms ( on
the basis of documents alone) as well as
consistency of docs with each other.
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Protection to Banks
• Banks are not responsible :
for the genuineness or contents of any
documents submitted (Art. 34)
For losses etc. arising from transmission
problems (Art. 35)
Force Majeure ( Art. 36)
For the failings of their correspondent Banks
(Art. 37)
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Protection to Banks
• Issuing Bank is responsible for all Bank
charges and other costs at home or abroad
even if they are supposed to be paid by other
party (Art. 37 c).
• Applicant is responsible for any adverse
consequences of foreign laws (Art. 37d).
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LETTER OF CREDIT
Appraisal / Assessment
• satisfactory track record.
• dealings with only one bank.
• Liabilities of the applicant to the Bank and third
parties.
• Means by which the applicant is expected to
meet his commitment once the bills arrive.
• Margin he should deposit.
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Appraisal Issues..
• Limit to be commensurate with turnover and CC
limits.
• Should be for genuine trade/ manufacturing activity.
• Usance period of the LC should ordinarily have
relation to the working capital cycle.
• Level of inventory carried should be commensurate
with industry norms / past trends.
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Appraisal Issues….
• LCs for purchase of machinery / capital goods should be
backed by borrower’s own funds or a term loan
sanctioned for the purpose.
• Wherever warranted, in addition to margin, where
prescribed, we may also retain a lien on the undrawn
portion of the CC limit for the value of bills to be
received under the LC.
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Appraisal Issues
• Sister concerns:
– Where the opener and beneficiary are sister concerns,
LCs should not normally be necessary.
– Take care of kite-flying operations.
– Standing of the beneficiary.
• D/A facilities to applicants of undoubted standing and
where security available is much more than the value of
LC.
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Appraisal Issues
• While computing purchase of imported material on LC
basis take net of import duty.
• Assess limits for usance and sight LC separately.
• Usance period should not exceed the production cycle
excepting in the case of bulk imports.
• Keep in mind the accepted projections regarding Sundry
Creditor levels.
• Margins & security depending on track record.
• Cash budget monitoring to track availability of funds.
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Appraisal Issues….
Revolving LCs:
– To be valid for not more than 1 year
– The limit should be a sub-limit.
– The LC value should be restored for further
negotiation only after the advice of retirement of the
previous bill has been received from the issuing bank
by the beneficiary bank.
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ASSESSMENT OF LC LIMIT
•
While assessing Letter of Credit Limit, the
following points need to be noted:
 Purchases of RM on LC basis should be net of
Import Duty; LC amount should cover FOB, CIF
or C&F value of goods- should not include
customs duty and other charges payable in India.
Payment of these charges should be taken care of
by the main working capital(CC) A/C of
Applicant.
 Transit time should be treated as ‘Nil’ if usance
period starts from shipment date.
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Other issues
Arriving at D.P:
– Ensure that the stocks covered by bills which have been
received under LCs opened by us, and not yet retired, are not
included for computing the D.P. in CC account.
Devolvement of LCs:
– In case of irregularity in CC account do not open further LCs.
– Take adequate margins and step up in case of it becoming a
habit – in worse cases stop further issues.
– Mark lien on DP so that usance bills are properly retired on due
date.
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Treatment of stocks covered by
Usance LC
Lien should be earmarked against advance value of
stocks for the outstanding usance LC bills.
This ensures provision of margins on the stocks covered
by usance LCs right from the time the stocks are bought
on credit backed by the Bank’s commitment.
Thus, it ensures that the margin is available well before
the CC a/c is debited for the matured LC bill.
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Treatment of stocks covered by
Usance LC
In some cases it is quite possible that the units
may not be in a position to provide margins right
from the time of purchases against LCs. In such
cases, based on merits, earmarking of lien for the
value of usance LC bills outstanding may be
permitted against the aggregate ‘market value’ of
stocks (including the LC stocks) instead of against
the ‘advance value’ of securities.
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Precautions
The limits for demand LCs and usance LCs should be
assessed separately with ample justifications.
The usance period should not, generally, exceed the
production cycle.
In case of bulk imports, establishment of LCs for longer
usance period may be considered selectively.
When liability under LC is met by creating an
irregularity in the Cash Credit account, the relative LC
limit should not be released for opening further LCs till
the account is adjusted.
Frequent Devolvement's: Warning signal!
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Assessment of LC Limit
• We assume that:
- Annual consumption of material to be
purchased under LC ………
C (Rs..)
- Lead time from opening LC to
shipment:
L (months)
- Transit time:
T (months)
- Credit (usance) period available: U (months)
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Assessment of LC Limit
• L+ T+ U = Purchase Cycle: P (months)
• LC Limit = P x C/12
Say, lead time, i.e. time from order placement
to shipment
= 10 days
Transit period
= 20 days
Usance period from arrival of goods= 3m
Total Purchase Cycle
= 4m
Monthly consumption of material = Rs 100
lacs
LC Limit(4 x 100) = Rs 400 lacs
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ASSESSMENT OF LC LIMIT :
M/s XYZ COMPANY LIMITED
LETTER OF CREDIT LIMIT OF Rs. 20 CRORES
(Rs. in crores)
Total purchase of Raw Materials (RM)
Purchase of RM under LC
172.64
69.41
Average monthly purchase of RM
[A]
5.78
Average usance period
[B]
3 months
Lead time & transit period
[C]
1 month
Total of [B] & [C]
[D]
4 months
Requirement of LC Limit [A] x [D]
23.12
LC Limit recommended
20.00
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Assessment of LC Limit
• Let us assume as follows:
(Rs in lacs)
i) Annual purchase of RM:
3200
ii) RM purchase under LC(50%): 1600
iii) Purchase under demand LC: 800
iv) Purchase under usance LC:
800
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Assessment of Demand LC
Limit
• Time gap from opening till shipment: 1 m
• Transit period from date of shipment
till date of retirement:
0.5 m
• Demand LC Limit: 800 x 1.5/12 = Rs 100 lacs
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Assessment of Usance LC Limit
• Lead Time, i.e from opening
LC till shipment:
1 month
• Transit Period, i.e. from date
of shipment till date of receipt of documents by
importer:
0.5 months
• Average usance period:
2 months
• Usance LC Limit: 800x3.5/12= Rs 233 lacs
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