Letter of credit
Also called: LC · Topic: Banking Regulation, NPAs and Financial Stability · NCERT: Beyond NCERT
Meaning
A letter of credit (LC) is a written promise by the importer's bank to pay the exporter. The bank pays once the exporter presents the documents listed in the LC, such as shipping papers and invoices. It removes the exporter's fear of non-payment, because a bank now guarantees payment instead of an unknown foreign buyer. This makes it a key tool of trade finance. International LCs usually follow the UCP 600 rules.
Example
An Indian firm imports machinery from Germany. Its bank in Mumbai opens an LC in favour of the German seller. Once the seller ships the machines and submits the bill of lading and invoice, the Mumbai bank pays. The importer then repays its own bank.
Don't confuse with
- Bank guarantee: a bank pays only if its customer fails to meet an obligation. Under an LC, payment is the normal route once the documents are in order.
- Letter of Undertaking (LoU): a guarantee used to raise short-term credit from overseas branches of Indian banks. LoUs were misused in the PNB-Nirav Modi fraud and discontinued by RBI in March 2018.
Related concepts
- CASA ratio
- Credit-deposit ratio
- Base rate
- Marginal Cost of Funds based Lending Rate
- External Benchmark Lending Rate
- Loan-to-value ratio
- Adverse selection
- Credit information company
- Factoring
- Trade Receivables Discounting System