Types of Letters of Credit. Banks may
issue several types of letters of credits. It is best for importers and
exporters to meet with their banking officer to determine which type of
credit best suits their needs. The most common types of letters of
credits are:
• Revocable
• Irrevocable
• Transferable
• Confirmed
• Unconfirmed
• Back-to-back
• Standby
• Cash advance against letter of credit
Revocable
A revocable letter of credit allows for amendments, modifications and
cancellation of the terms outlined in the letter of credit at any time
and without the consent of the exporter or beneficiary. Because this
places the exporter at risk, revocable letters of credit are not
generally accepted.
Irrevocable
An irrevocable letter of credit requires the consent of the issuing
bank, the beneficiary and applicant before any amendment, modification
or cancellation to the original terms can be made. This type of letter
of credit is commonly used and preferred by the exporter or beneficiary
because payment is always assured, provided the documents submitted
comply with the terms of the letter of credit. Irrevocable letters of
credit can be both confirmed and unconfirmed (See below).
Transferable
An irrevocable letter of credit may also be transferable. With a
transferable letter of credit, the exporter can transfer all or part of
his rights to another party. Transferable letters of credit are often
used when the exporter is the importer's agent or a middleman between
supplier and importer, and not the actual supplier of merchandise. With
a transferable letter of credit, the exporter uses the credit standing
of the issuing bank and avoids having to borrow or use his own funds to
buy goods from a supplier. Hence, it is a viable pre-export financing
vehicle. Before transfer can be made, the exporter must contact, in
writing, the bank handling the disbursement of funds - the transferring
bank. Transferable letters of credit can only be transferred based on
the terms and conditions specified in the original credit, with certain
exceptions. Therefore, it may be difficult to achieve flexibility and
confidentiality with this finance method.
The transferring bank, whether it has confirmed the letter of credit
or not, is only obligated to effect the transfer to the extent and in
the manner expressly specified in the letter of credit. Transferable
letters of credit involve specific risks. When a bank opens a
transferable letter of credit for a buyer, neither party can be certain
of who will be the ultimate supplier. Both parties must rely upon the
importer's assessment of the exporter's reputation and ability to
perform. To reduce overall risk and prevent the shipment of substandard
goods, an independent certificate of inspection can be required in the
documentation.
For simplicity's sake, many banks prefer single transfer and
discourage multiple transfers, but will do multiple transfers if
conditions are right. Partial transfers can also be made to one or
several suppliers if the terms of the original letter of credit allow
for partial shipments. The processing of this type of letter of credit
can become complicated and tricky, requiring logistics coordination and
the highest level of precision. Incomplete and/or ambiguous information
on the transferable letter of credit almost always leads to problems.
Furthermore, the beneficiary of the transferable letter of credit must
be available throughout the entire negotiation process to assist the
transferring bank.
Other forms of irrevocable letters of credits,
though not widely used, are unconfirmed, confirmed and back-to-back.
Confirmed
A confirmed letter of credit is when a second guarantee is added to the
document by another bank. The advising bank, the branch or the
correspondent through which the issuing bank routes the letter of
credit, adds its undertaking and commitment to pay to the letter of
credit. This confirmation means that the seller/beneficiary may also
look to the credit worthiness of the confirming bank for payment
assurance.
Unconfirmed
An unconfirmed letter of credit is when the document bears the guarantee
of the issuing bank alone. The advising bank merely informs the exporter
of the terms and conditions of the letter of credit, without adding its
obligation to pay. The exporter assumes the payment risk of the issuing
bank, which is typically located in a foreign country.
Back-to-Back Letters of Credit
Back-to-back letters of credit are two individual letters of credit that
together offer an alternative to a transferable letter of credit. The
back-to-back letter of credit allows exporters (sellers or middlemen)
who do not qualify for unsecured bank credit to use a letter of credit
as security for a second letter of credit in favor of a supplier. In
other words, if a foreign buyer will issue a letter of credit to an
exporter, certain banks and trade finance companies will issue
independent letters of credit to the exporter's suppliers so that the
required goods can be purchased. Even if the initial letter of credit is
not successfully completed, the second remains valid, and the issuing
bank is obligated to pay under its terms.
Although back-to-back letters of credit provide small and medium
exporters virtually unlimited working capital to finance their sales and
complete more export transactions, many banks are reluctant to take on
this type of arrangement. Because back-to-back letters of credit involve
two separate transactions, it is likely that several participating banks
will be involved and the risk of confusion and dispute is high. To
protect itself, a bank generally will require that the exporter present
all relevant documents that are part of the first letter of credit
before issuing the second letter of credit. The second document is
worded to conform precisely to the original and dated to expire at some
date prior to the first, ensuring that the seller has sufficient time to
present documents within the time limits of the first.
Standby Letter of Credit
Unlike a commercial letter of credit, which is basically a payment
mechanism, a standby letter of credit is a form of a bank guarantee. It
may be used as necessary to cover nonpayment of a financial obligation.
A standby letter of credit normally is intended to be drawn on only in
the event of nonpayment. The standby letter of credit is issued by the
bank and held by the seller, who in turn provides the customer open
account terms. If payment is made according to the seller's terms, the
letter of credit is never drawn on. However, if the customer is unable
to pay, the seller presents a draft, and all other documents as
required, to the bank for payment. The standby letter of credit
typically expires within 12 months.
Cash Advance Against Letter of Credit
A cash advance against a letter of credit works like back-to-back
letters of credit, with the exception that the bank or financing company
will issue cash to the suppliers instead of another letter of credit.