Where the Credit Risk Lies in Letters of Credit

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What are “letters of credit”?

And where is the credit risk?

A letter of credit is a bank product that solves a problem for two parties to an import/export transaction

I want to export my goods to my

customer …….but I don’t want to lose

control of them until I’m paid

The exporter’s problem

I want to import goods from my

supplier but I don’t want to pay until I

have them

The importer’s problem

To resolve the problem the importer can apply to his or her bank for an import letter of credit………. ……which is really just a type of guarantee issued by the bank to the exporter

But how does that help? The goods still have to be paid for and they can’t be shipped until payment is made…..

….can they?

Okay, so here’s how it works……

The importer instructs the bank to issue an import letter of credit on his or her behalf in favour of the exporter…….

….but, importantly, the importer gives the bank a list of the documents that he or she wants to see before payment will be made to the exporter under the import letter of credit. These documents will assure the importer that the goods shipped are exactly what has been ordered.

In that list of documents there would always be something to confirm that the goods have been placed on some form of transport (a ship, a plane, a truck etc.) to prove that they are on the way to the importer.

Other documents might include; An invoice issued to the importer describing the

goods and the amount of the transaction An insurance certificate (depending on who is

responsible for insuring the goods while in transit)

An independent certification of inspection And anything else that the importer specifies

The bank prepares the letter of credit and sends it to the exporter’s bank (or an agent bank in the exporter’s country) who will then advise the exporter that it has been issued. The letter of credit will have an expiry date and will include a date by which the goods have to be shipped from the exporter’s country.

The exporter then decides whether he or she can meet the documentation requirements of the letter of credit as well as the deadlines for shipping the goods and submitting the required documents to the bank.

Once the goods are shipped and the correct documents submitted to the bank……the exporter gets paid (usually) and the documents are then sent to the importer via his or her bank.

There are two important points to note here;

The bank issuing the letter of credit has no interest in the goods themselves – only the documents

and…..

A letter of credit is always irrevocable so once the correct documents are submitted by the exporter to the local agent bank and the letter of credit is still valid, the bank has to pay

Okay, that’s all well and good but where’s the credit risk?

That last bit about the letter of credit being irrevocable? That’s the problem for the bank.

When the correct documents are submitted by the exporter and the letter of credit has not expired, the bank has to pay and, at that point, the importer’s bank account is debited with the amount paid to the exporter.

The credit risk, of course, is that there are no funds in the importer’s bank

account at the time to meet the payment or, much worse, that the importer has gone out of business

since the letter of credit was issued.

That means that the bank can’t withdraw the letter of credit, it can only expire if the

bank is to avoid its liability.

The really big problem for the bank is that the letter of credit has no “get-out” clause

as a normal guarantee usually does – that’s what makes it irrevocable.

So how does the bank mitigate the credit risk?

The normal credit risk assessment approach applies just as though the bank is providing an overdraft or loan because that might be what results when the letter of credit is paid.

But, because of the irrevocable nature of the letter of credit, it would be normal to seek collateral unless the letter of credit is being issued on behalf of a very strong client with a solid track record and financial position.

If the client has available funds in the bank account at the time the letter of credit is issued, the best form of collateral would be to take the cash and hold it on a separate account until payment or expiry of the letter of credit (whichever comes first).

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