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Letter of Credit - Introduction

INTRODUCTION - LETTER OF CREDIT

Modern banks facilitate trade and commerce by rendering valuable services to the business
community. Apart from providing appropriate mechanism for making payments arising
out of trade transactions, the banks gear the machinery of commerce, specially in case of
international commerce, by acting as a useful link between the buyer and the seller, who
are often too far away from and too unfamiliar with each other. Opening or issuing letters
of credit is one of the important services provided by the banks for these purposes. The
foundation of the banking business is the confidence reposed in the banking institutions by
the people in general and the mercantile community in particular. The standing, reputation
and goodwill earned by a banking institution enables it to issue instruments, known as
Letters of Credit, in favour of traders and banks to meet the needs of their customers. In fact,
a letter of credit carries a promise or an undertaking by the issuing banker which is valued
and honoured on a global basis.
In actual practice, a Letter of Credit means “a document issued by a banker authorising
the banker to whom it is addressed to honour the bills of the person named therein to the
extent of certain amount.”

Definition

A Letter of Credit has been defined by the International Chamber of Commerce as “an
arrangement, however, named or described whereby a bank (the issuing bank) acting at the
request and in accordance with the instructions of a customer (the applicant of the credit),
is to make payment or to the order of a third party (the beneficiary) or is to pay, accept or
negotiate Bills of Exchange (Drafts) drawn by the beneficiary or authorise such payments to
be made or such drafts to be paid, accepted or negotiated by another bank, against stipulated
documents and compliance with stipulated terms and conditions.”
From the above definition of Letter of Credit, it is clear that there are following parties
to a Letter of Credit.
(1) The buyer.
(2) The beneficiary.
(3) The issuing bank.
(4) The notifying bank.
(5) The negotiating bank.
(6) The confirming bank.
(7) The paying bank.

Types of Letters of Credit

The Letter of Credit can be divided into two broad categories:
1. Travelers’ Letter of Credit.
2. Commercial Letter of Credit.

Opening a Letter of Credit

A banker runs great risks in opening a letter of credit. Therefore, to protect his interest he
must be very careful.

ADVANTAGES OF LETTER OF CREDIT

1.Advantages to the Exporter
2.Advantages to the Importer

Precautions Taken by the Bank

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