IFM UNIT 6 - LC Mechanism

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International Financial Management

Unit 6

LC Mechanism

Dr. Anuradha Yesugade, Faculty BVIMED,Pune


3. Documentary Credit Method: (Letter of Credit: LC)

This method lies between above two methods i.e. Open Account and Advance Payment.

In open account method the seller (exporter) bears the risk,

and in Advance Payment method the buyer (Importer) bears the risk.

But here in Documentary Credit method it is the Banker who plays the role of intermediary and assures
Payment to Exporter and Performance to the Importer.

Banks gives assurance of payment to the exporter,

you send the goods as per the specifications, I commit to Pay”

On the other hand Bank assures to the importer

“I will not debit your account till the goods are not up to specifications”
Features:

1. There are Three Contractual Relationships in the use of Documentary Credits:

✔ The relationship between the Importer and the Exporter

✔ The contractual relationship between the Importer and Importer’s bank

✔ Issuing Bank and the Beneficiary (i.e. Seller/Exporter)


2. The parties concerned with Letter of Credit are described below:

a. Applicant: is the Importer who requests his Bank to Open a LC

b. Beneficiary: The Party in whose favour the LC is issued, generally the Exporter.

c. Issuing Bank: Is the Importer’s Bank, which generally issues the LC

d. Advising Bank: The bank from Exporter’s Country, determines the authenticity of
LC before forwarding it to the beneficiary.

3. A Letter of Credit assures the payment only if its terms and conditions are
satisfied by compiling the necessary documents.
4. The quality and quantity of goods shipped depends upon the honesty and integrity of the seller,
who has manufactured, packaged the goods and organized the delivery.

5. If the documents are not compliant the Bank will not effect the payment and if in such case of
discrepant documents if bank effects the payment and debit the importer’s account, then bank has
to re credit importers account again.

6. While preparing a shipment covered under LC, it is very much important to closely follow the
instructions in the LC.

✔ LC will explain exactly, how to prepare a draft, commercial invoice, which other documents must be
prepared and attached to the draft for payment, what the deadline to ship the goods is and when to
present the documents for payment.

✔ In all this entire process accuracy is extremely important.


7. The Letter of Credit Process has been standardized by a set of rules published by ICC. These
rules are called the Uniform Customs and Practise for Documentary Credits (UCPDC).

Merits:

1. Both the Exporter and the Importer gets the assurance of Payment and Performance
respectively.

Risks:

1. Noncompliance of documents by the seller (Exporter) may lead to delay in the settlement process.

2. Bank deals only with “documents representing the goods” and not the goods themselves.

3. Seller may face commercial risks, political and foreign exchange risks
When this method can be opted:

1. When both the parties to the trade are not having established trade relationship from many years.

2. When the Importer’s creditworthiness is not known


LC Mechanism
Step 1:

✔ The exporter and importer have entered in to the cross border trade contract.

✔ The nature of contract is about the flow of goods from exporter to importer
and correspondingly flow of foreign currency (money )from the importer to
the exporter
Step 1:

✔ Toward early settlement flowing methods are available:

I. Open Account
II. Advanced payment
III. Documentary Credit
IV. Documentary collection
V. Consignment
VI. International Trade Guarantees

Out of all above 5 methods both parties have mutually agreed to opt for
documentary credit /letter of credit as a method of their trade settlement
Step 2:

✔ Accordingly exporter, requests importer to open a letter of credit in favor of him .

✔ In order to open a letter of credit importer (applicant) of LC approaches his banker (opening banker) with a
request to open a LC in favor of exporter (beneficiary ).

✔ The banker while opening LC insists upon following documents:


I. LC application form
II. Firm order
III. Relevant clause declaration
IV. Margin /Deposit
V. License ( if required )

• The banker will carefully go through these documents and if satisfied about credentials of the importer may open a LC.

• However at times due to some political /sociological factors (rivalry between applicant and beneficiary’s countries ) banker
may not agree to open LC even though applicant has fulfilled all conditions and submitted all above documents .
Step 3:

• The LC opened is to be forwarded to beneficiary.

• However the LC opening banker forwards same not directly but through another bank which is called as
Advising Bank.

• As per clause-the role of Advising Bank is to confirm the authenticity of the LC genuineness of the
instrument titled LC. The advising bank is generally from the exporter’s country.

• If an advising bank takes an additional responsibility of effecting payment over and above determining
authenticity then such advising bank is called as Confirming Bank.

• In that case the advising bank steps into the shoes of LC opening bank and documents will be sent to such
advising bank for scrutiny and payment. The reimbursement for which will be claimed from opening banker
only.

• The above confirmation is asked of by the exporter when he doubts the capacity of the banker to fulfill the
commitment .It should be noted that adding confirmation is not obligation for the advising bank.
Step -4:
✔ The LC so received duly confirmed /authenticated is taken up by the exporter for further processing
of LC.

✔ By processing we mean collecting documents evidencing performance the documents so collected


are of following types:

i. Financial documents
ii. Commercial documents
iii. Transport documents
iv. Risk bearing documents
v. Other documents

•All such a documents tied together makes an Export Bill which is forwarded to Exporter’s Bank for
negotiation.
Step -5:
• In simple terms Negotiation means Bill Discounting or financing of export transaction at post
shipment stage.

• The exporter’s bank may or may not negotiate. In either case the export bill is sent to the LC
opening banker for final payment.

•If exporter’s bank decides to negotiate the bill then it will make detailed scrutiny of the bill and ensure
compliances to terms and conditions of the LC.

•If documents are in order the exporter bank would effect the payment and forward the bill to the LC
opening bank with reimbursement claim.

•It is pointed out here that the decision to negotiate is not binding / compulsory .As per the latest clause
simply by agreeing to negotiate constitutes negotiation whether financing has been done or otherwise.
Step -6:
• Whether negotiated or otherwise documents are received at the counters of
the LC opening bank for final payment.

• The LC opening bank would make detailed scrutiny of the documents as


per terms and conditions stated in the LC application form.

• If documents are in compliance to the terms and conditions of the LC ,


means exporter has performed and therefore importer’s bank has to
either effect the payment as per commitment /promise / undertaking
or honor the reimbursement claim if any lodged by exporter bank .
• Here, it is pointed out that the LC opening banker effects the payment and later
on draws (debit) on importer’s account

• Before effecting the payment the LC opening banker makes detailed scrutiny of
the documents and ensures that documents are in compliances to the terms and
conditions of LC .

• As per UCPDC article 14 clause (B) five working days following the day of
presentation have been provided to make the scrutiny of documents.

• Documents can be in order : Effect the payment

• Documents may be discrepant: ????


•In case documents are found to be discrepant (performance is not shown) then steps to be
followed (article 16) are as under:

a) The issuing bank on its sole judgment finds that documents are not in compliance, then
may approach the applicant for waiver of the discrepancy.
b) If issuing bank decides to refuse to honor it must be a single notice to that effect to the
presenter and notice must state following:
i. Banker is refusing to honor or negotiate
ii. Clearly state discrepancy due to which banker is refusing to honor or negotiate
iii. Banker is holding documents until waiver is received from the applicant
iv. Banker is returning the documents

•All the above steps have to be followed with the help of fastest telecommunication means
not later than 5th banking day following the day of presentation of documents.
Step 7:

• Now if documents are in order then following procedure is required to be


followed for the

• D/P i.e ” SIGHT bills “(deliver documents against payment )

• and D/A i.e “USANCE” bills (deliver documents against acceptance ).


• D/P i.e ” SIGHT bills “(deliver documents against payment )

✔ In case of D/P bills if the documents are found to be in order,

✔ then, banker (L/C opening banker) as per commitment has to effect payment to the
exporter and later on debits importer’s account

✔ As an extreme case if the importer declares insolvency

✔ banker would clear the goods by taking documents to the port and sell this goods in the
domestic market and thus recovers the money paid to the exporter .

✔ In financial terms it is called as floating charge over the goods and under any
circumstances the banker would not release the charge (documents) unless debit gets
existed.
D/A i.e “USANCE” bills (deliver documents against acceptance ).

✔ As against this in case of D/A bills risk is relatively higher as banker has to release
documents that is release the charge and debit will be drawn only on due date of
the bill .

✔ the risk here is on due date if documents are in order exporter would get payment
and banker in the event of debit not getting adjusted cannot exercise charge over
the goods

✔ On due date If importers fails to maintain balance then , the banker will file a case
against importer for liquidation of security by producing accepted bill of exchange
as an evidence of having agreed to pay the bill on due date .
Step – 8:

•The importer on getting documents duly endorsed from the banker, would go to the
port and clear the goods.

•(The endorsement is required as bill of lading is in the name of banker as a


consignee and titled the goods has to be transferred to the importer.)

•The exporter has already received the payment from the bank as per commitment
thus the banker assures payment to the exporter and performance to the importer.
To conclude:

• Out of the all methods of trade settlement available, the documentary credit
method is most popular one in the cross border trade transactions. It is observed
that more than 75% cross border trade is settled through DOCUMNTED CREDIT
(Letter of credit) mechanism only. In spite of advantages of L/C, there are many
cases which are under dispute and referred to ICC to redress disputes.

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