A letter of credit is an arrangement whereby a bank at the request and in accordance with the instructions of a customer (importer) is to make payment to or to the order of a third party (exporter) or is to pay, accept or negotiate bills of exchange drawn by such third party or authorities such payment or negotiation by another bank, against stipulated documents, provided that the terms and conditions of the credit are complied with.
Simply stated, a letter of credit is an arrangement whereby the bank undertakes to pay drafts on itself drawn in terms of the credit. Mechanism of a Letter of Credit. The following steps brings out clearly the operation of a letter of credit. The process of a letter of credit summarized is detailed below:
1. The transaction originates when the exporter in London and the importer in Mumbai enter into a contract of sale. The contract covers all important particulars like the description, value and quantity of goods, the clue date for shipment, method of payment, etc. One of the stipulations may be that a letter of credit should be opened in favor of the exporter.
2. The importer would apply to his bank (Bank of India) requesting and authorizing the bank to open a letter of credit in favor of the exporter and pay bills drawn by the exporter under the letter of credit. The application would stipulate the conditions, especially with regard to the documents to be submitted by the exporter along with the bill.
3. On the strength of the application from the importer, the bank would issue a letter of credit. It would be addressed to the exporter and contain an undertaking by the bank that bills drawn under the letter of credit would be paid by it provided the conditions stipulated therein are met.
4. Though the letter of credit is addressed to the exporter, it would normally be sent by the correspondent bank of Bank of India in London (Midland bank) with a request to forward it to the beneficiary. The necessity arises because the exporter would not know the signature of the officials of the Bank of India and hence he would not be in a position to satisfy himself about the genuineness of the letter of credit. Then it is sent to the Midland Bank who, in the capacity of a correspondent bank, is in possession of the signatures of the officials of Bank of India, the signatures on the letter of credit are verified before it is forwarded to the exporter.
5. Within the stipulated date of shipment the exporter ships the goods to a port in the importer’s country (Mumbai ) and obtains bill of lading from the shipping company.
6. The exporter draws a bill of exchange on Bank of India or the importer as may be stipulated in the letter of credit and along with the bill of lading and other documents required presents them for payment to his bank (say, Midland Bank). Since it is a bill under letter of credit and payment is ensured, any bank in the exporter’s country would be willing to pay against it.
7. The exporter’s bank would verify the documents to make sure that they satisfy the conditions stipulated in the letter of credit and pay the amount to the exporter. Then the documents would be forwarded to Bank of India for payment.
8. On receipt of the documents and after verifying that they satisfy the requirements of the letter of credit, Bank of India would make payment to Midland Bank. The amount of the bill would be recovered by the bank from the importer and the documents would be delivered to him.
In the above credit, the importer is the applicant for the credit; Bank of India which issues the letter of credit is the issuing or opening bank the exporter is the beneficiary under the credit; Midland Bank is the intermediary bank which acts as the advising bank while forwarding the letter of credit to the beneficiary and as negotiating bank while paying against the bill drawn under the letter of credit.