Unit 7

Trade Finance
Trade finance represents the financial instruments and products that are used by companies to
facilitate international trade and commerce. Trade finance makes it possible and easier for
importers and exporters to transact business through trade. For any transaction there should be a
seller to sell the goods and services and a buyer to will buy the goods and services. Bank and
financial institutions facilitate these trade transaction by financing the trade.

Bank-intermediated trade finance (or trade finance, in short) performs two vital roles: providing
working capital tied to and in support of international trade transactions, and/or providing means
to reduce payment risk.

Trade finance is the term used to describe the tools, techniques, and instruments that facilitate trade
and protect both buyers and sellers from trade-related risks. The purpose of trade finance is to
make it easier for businesses to transact with each other. It also helps to reduce the risks involved
in global trade, for both buyers and sellers.

When a trade transaction takes place, the buyer and seller incur different types of risk. For the
buyer, there is a risk that the goods purchased will not arrive on time or will fall short of the
expected quality or volume. The seller, meanwhile, faces the risk that payment will not be received
on the agreed terms for the goods provided.

These risks are exacerbated in an international trade transaction, as resolving any disputes can be
time consuming and difficult – particularly when the markets involved have different cultures and
regulatory climates.

The main forms of trade finance include open account, advance payment, documentary collection,
letter of credit, Guarantee, Trade credit insurance, factoring, structured finance. Secure trade
finance depends on verifiable and secure tracking of physical risk and events in the chain between
exporter and importer.

Bank plays vital role in providing financial assistance and also comfort levels to the traders through
their financing called Trade finance. Trade finance is granted in the form of fund based finance
and non fund based finance to enable trader in their trading activities.
Funded and Non Funded Credit

Fund based credit facility (Funded Loan):

Funded loans are those loans where there is an actual transfer of funds from the bank to the
borrower. The bank disburses the loan i.e. physical cash to borrower then and there right after the
approval of credit facility. Borrowers are charged with interest rate on this type of loan on its
disbursement. As per NRB directive banks charge interest rate to customer on the basis of base
rate plus premium. Example: Home Loan, vehicle loan, Overdraft, Term Loan, Trust Receipt Loan,
Short Term Loan, Demand Loan, Credit card etc.

Non-Fund based credit facility (Non-Funded Loan)

Any type of credit facility which involves commitment of bank on behalf of customer for payment
to third party in case of need under some agreed conditions refers to non-funded credit facility. In
non-funded facility bank does not provide real cash rather providing commitment to third party
stating that if the customers fail to discharge the obligations, bank will do the same. It does not
require immediate outlay of funds and therefore the cost of such facilities tends to be lower than
cost of funded facilities. In non-funded loan bank charges commission rather than interest rate to
the borrower. Example: Letter of credit, Bank Guarantee.

GUARANTEE:
• A guarantee is an agreement through which an individual or legal entity undertakes to meet
certain obligations, such as paying a third party's debt if the latter defaults.
• A Bank Guarantee is an undertaking/promise of an issuing bank to pay to the beneficiary if the
applicant fails to perform the duties and obligation as per the contract between applicant and
beneficiary.
• A bank guarantee is an assurance to a beneficiary that the bank will uphold a contract if the
applicant and counterparty to the contract are unable to do so.
• Bank guarantees serve the purpose of facilitating business in situations that would otherwise
be too risky for the beneficiary to engage.
• Bank Guarantee a promise made by the bank to any third person to undertake the payment risk
on behalf of its customers. Bank guarantee is given on a contractual obligation between the
bank and its customers. Such guarantees are widely used in business and personal transactions
to protect the third party from financial losses. This guarantee helps a company to purchase
things that it ordinarily could not, thus helping business grow and promoting entrepreneurial
activity.

Parties in bank guarantee:

The applicant: The client on whose behalf guarantee is being issued.
The beneficiary: To whom guarantee is issued.
The guarantor: Issuing bank
Importance of Guarantee:

Increase credibility: Bank guarantee reflects the confidence of the bank on the business and
indirectly certify soundness of business and adds credit worthiness.

Assessment of business: Incase of foreign transaction or transaction with government

organization, the foreign party or a government undertaking is constrained and can not assess the
soundness of each and every applicant. In such case, bank guarantee acts as trusted instruments to
assess stability and creditworthiness of companies. It is a complicated process when it comes to
assessing the credibility of parties when it comes to foreign transactions. So, parties can use a bank
of guarantee in such a situation to assess each other’s creditworthiness as well as financial stability.

Confidence of performance: When new parties associate in the business and are sceptic about
the performance of the company undertaking the project, performance guarantees help in reducing
the risk of the beneficiary. A bank guarantee provides confidence when it comes to doing business.
It removes obstacles that can interfere with smooth business transactions such as lack of payment
or delivery of goods and services.

Risk reduction: The bank guarantee adds creditworthiness to both the applicant and the
contract. There is a risk reduction due to the bank's assurance that they will cover the liabilities
should the applicant default. This protects against any probable loss that party may suffer from
new seller. Due to low risk, it encourages the seller/beneficiaries to expand their business on a
credit basis.

Types of Bank Guarantee:

Bid Bond Guarantee

A bid bond provides a guarantee that a winning bidder will take up the contract as per the terms at
which they bid. A bid bond ensures compensation to the bond owner if the bidder fails to begin a
project. Bid bonds are often used in construction jobs or other projects that follow a similar bid-
based selection process.

• Part of bidding/tender process

• Generally used in construction business by contractor
• The bonds have fixed expiry date which generally coincides with the expected date of
completion of bidding process and signing contract with successful bidder. Gives assurance for
non withdrawal of bid before expiry
• Gives assurance that bidder would undertake the contract upon successful bid selection
• Outstanding till tender process/result
• Converted into performance bond if accepted and guarantee released if rejected. On the
completion of bidding process, the bonds are retuned to unsuccessful bidder. If the successful
bidder does not sign the contract, the beneficiary usually invokes the bid bond. Bid bonds are
therefore more in nature of performance guarantee.
Performance Bond Guarantee
Performance Bond Guarantee is issued for honoring a particular project/task to contractor along
with giving a assurance for successful completion of project/task within stipulated time as per
contractual agreement and

• Issuing bank provides a guarantee to the beneficiary to make good the moneytary loss in the
event of non performance or short performance of a contract by the client.
• Issue of performance guarantee involves an assessment of technical competency, managerial
ability or vocational experience to execute the contract successfully.
• The commitment of issuing bank to pay amount is in fact payment of penalty for non
performance of task by the client.
• Needed after successful acceptance of bid
• Gives contractor proceed to work
• Assurance for successful completion of project within stipulated time.
• Protects a project owner from contractor’s failure to perform according to contractual terms
• May raise need of advance payment guarantee

Advance Payment Guarantee

Advance payment guarantee is issued to provide advance payment needed by contractor for
completion of job or contract and also protect beneficiary for advance payment made by them to
contractor.

• Advance payment guarantee are issued by the bank on behalf of customers who are in the
business of major export order, construction contract etc which involves high outlay of funds.
• Such providers of product/service need funds n advance from time to time for purchase of raw
materials, making labor payment etc. Such advance payment also forms part of the contract
entered into by the supplier and buyer.
• The buyer releases the advance payment only after bank issue advance payment guarantee
which ensures repayment of advance amount incase latter fails to complete a contract as agreed.
• Needed when contractor need advance payment from beneficiary
• Generally needed on large amount contract
• Protects beneficiary for their advance payment
• Refund of advance payment is guaranteed, if contractor fails to complete job or breach of
contract.

Financial Guarantee
A financial guarantee is a type of promise given by a guarantor to take responsibility for the
borrower in the case of default in payments to the lender or investor. It may be defined as
procurement of tangible assets against production of bank guarantee is known as financial
guarantee. So a financial guarantee may be seen as a certificate issued by the bank regarding
financial ability/worth of its client to meet certain financial obligation making payments and
satisfying the dues etc.
Deferred Payment Guarantee
Sometimes bank is required to issue a guarantee for making payment to the suppliers of goods,
plant and machinery to the borrower on deferred terms in agreed installments with provision for
charging a stipulated interest on the respective due dates incase of default in payment by the buyer.
• It is issued by the bank at the request of buyer for the purchase of goods or machineries from
beneficiary/seller on term of payment after specific period and to give surety to beneficiary for
their payment.
• Needed in trading of goods and machineries
• Provide certain fix time for buyer to settle the credit
• Give assurance to a beneficiary/seller for payment of goods and machineries
• Have specific time period of expiry in which all outstanding credit amount shall be paid to
beneficiary.

Payment Guarantee/Loan guarantee:

A loan guarantee is a promise to pay all or part of the principal and or interest on a debt obligation
in the event of default of the borrower. If party fails to pay, guarantor is bound to pay on behalf of
defaulting borrower

Foreign Bank Guarantee:

Guarantee that is issued for a foreign beneficiary is called foreign bank guarantee.

Guarantee for warranty or warranty bond:

A Warranty Bond is a contract between an owner, a contractor, and a surety company. Warranty
bonds guarantee that any work defects found in the original construction will be repaired during
the warranty period. If the contractor can't fix the defects, the owner will be repaid.

LETTER OF CREDIT

There are several uncertainties that arise when buyers and sellers across the globe engage in
maritime trade operations. Some of these uncertainties revolve around delayed payments, slow
deliveries, and financing-related issues, among others. The sheer distances involved in
international trade, different laws and regulations, and changing political landscape are just some
of the reasons for sellers needing a guarantee of payment when they deliver goods through the
maritime route to their sellers.

Due to the nature of international dealings, including factors such as distance, differing laws in
each country, and difficulty in knowing each party personally, the use of letters of credit has
become a very important aspect of international trade. Letters of credit are used to minimize risk
in international trade transactions where the buyer and the seller may not know one another. Letters
of credit were introduced to address this by adding a third party like a financial institution into the
transaction to mitigate credit risks for exporters.
A letter of credit is essentially a financial contract between a bank, a bank's customer and a
beneficiary. Generally issued by an importer's bank, the letter of credit guarantees the beneficiary
will be paid once the conditions of the letter of credit have been met.

Letter of Credit is a contractual commitment by the foreign buyer's bank to pay once the exporter
ships the goods and presents the required documentation to the exporter's bank as proof.

Letter of credit is non funded facility, however, may be converted into funded facility in case of
default made by buyer.

Importance of letter of credit

Safely expand business internationally: A letter of credit gives the trade partner an ability to
transact with unknown or in newly established trade relationship. It helps in expanding their
business into new geographics.

Highly customizable: A letter of credit is highly customizable. Both the trading partners can put
in terms and conditions as per their requirement and arrive at a mutual list of clauses.

Seller receives money on fulfilling terms: A letter of credit makes issuing bank independent of the
trading partners obligation and any dispute arising out of those obligation. The bank has to check
whether documents submitted by the beneficiary satisfy terms and conditions specified in the letter
of credit and pay full amount.

Works as credit certificate to a buyer: A letter of credit transfers the credit worthiness from
importer or buyer to the issuing bank. The importer can do multiple transaction at the same time
when backed by established and larger institution such as bank.

Seller is free of credit risk: A letter of credit is safer for seller or exporter in case the buyer or
importer goes bankrupt. Since credit worthiness of the importer is transferred to issuing bank, it is
bank’s obligation to pay the amount as agreed in letter of credit.

Process of LC

• Buyer and seller agree to conduct business. The seller want a letter of credit.
• Buyer applies to his bank (called issuing bank) for letter of credit in favor of the seller.
• Issuing bank (after doing a credit check to determine if importer is creditworthy) opens L/C
and requests that a bank in exporter’s country (called the advising bank) advise the exporter
of the L/C
• Advising bank authenticate the credit and advises exporter of L/C in the exporter’s favour
• The exporter delivers the goods to the point of departure. The freight-forwarder prepares the
necessary documentation. These documents represent title to the goods, including the bill of
lading
• Export documents of title (invoices, bill of lading, insurance certificate etc.) are sent by the
exporter to the advising bank. If the exporter has agreed a credit period with the importer then
a time draft is attached to the documents. If no credit period is agreed, this document is a sight
draft, i.e. a draft payable immediately
• Seller presents the required documents to the advising bank to be processed for payment.
• Advising bank examines the documents for compliance with terms and conditions of LC and
sends it to the issuing bank
• Either the importer pays immediately and is given the documents of title by the issuing bank
(‘documents against payment’) or if there is a credit period involved, the issuing bank accepts
the draft for payment at maturity
• Importer obtains documents of title
• Importer presents the documents to customs to obtain release of the goods
• Issuing bank sends payment to the negotiating bank (usually the same bank as the advising
bank) that is authorised to make payment to the exporter on behalf of the issuing bank.
FEATURES OF LETTER OF CREDIT

Negotiability
Letters of credit are usually negotiable. The issuing bank is obligated to pay not only the
beneficiary but also any bank nominated by the beneficiary.

Negotiable instruments are passed freely from one party to another almost in the same way as
money.

To be negotiable, the letter of credit must include an unconditional promise to pay on demand or
at a definite time. The nominated bank becomes a holder in due course.

As a holder in due course, the holder takes the letter of credit for value; in good faith; and without
notice of any claims against it. A holder in due course is treated favorably under the Uniform

Revocability
Letters of credit may be either revocable or irrevocable. Whether revocable or irrevocable, it will
state on the face of the document what type of credit is being presented.
A revocable letter of credit may be revoked or modified for any reason, at any time by the issuing
bank without notification. A revocable letter of credit cannot be confirmed.

If a correspondent bank is engaged in a transaction that involves a revocable letter of credit, it

serves only as of the advising bank.

Once the documents have been presented and meet the terms and conditions in the letter of credit,
and the draft is honored, the letter of credit cannot be revoked.

The revocable letter of credit is not commonly used. It is generally used to provide guidelines for
shipment.

The most commonly used irrevocable letter of credit may not be revoked or amended without the
agreement of the issuing bank; the confirming bank; and the seller (beneficiary).

An irrevocable letter of credit from the issuing bank insures the seller that if the required
documents are presented and the terms and conditions are complied with, payment will be made.

Transfer and Assignment

The seller has the right to transfer or assign the right to draw, under a letter of credit only when
the letter of credit states that it is transferable or assignable.
Letters of credit governed by the Uniform Commercial Code (Domestic) may be transferred an
unlimited number of times. Under the Uniform Customs

Practice for Documentary Credits (International) the credit may be transferred only once.
However, even if the credit specifies that it is nontransferable or non-assignable, the seller may
transfer their rights before a performance.

Sight and Time Drafts

All letters of credit require the seller to present a draft and specified documents to receive payment.

A draft is a written order by which the party creating it, orders another party to pay money to a
third party. A draft is sometimes referred to as a bill of exchange.

The two types of drafts used in letters of credit are sight and time. A sight draft is payable as soon
as it is presented for payment although the issuing bank is allowed a reasonable time to review the
documents before making payment.

A time draft is not payable until the lapse of a particular period stated on the draft (often 90 days).
The issuing bank is required to accept the draft as soon as the documents comply with the letter of
credit terms.

The issuing bank is then obligated to pay the draft at maturity.

TYPE OF LETTER OF CREDIT

Revocable letter of credit

A revocable letter of credit is a type of letter of credit in which the issuing bank can amend the
terms of the letter of credit or cancel the letter of credit completely without giving prior notice to
the beneficiary. Since revocable letter of credit do not provide any protection to the beneficiary,
they are not used. In addition UCP has no reference to revocable letter of credit. All credits issued
subject to UCP 600 are irrevocable letter of credit.

Irrevocable letter of credit

Irrevocable letter of credit is a type of documentary credit which can not be cancelled or amended
by the issuing bank without the agreement of the parties of the letter of credit transaction.
An ILOC gives the seller a guarantee that he/she will receive the fixed amount due, and also by
the right time from the buyer. As the name suggests, the document is irrevocable i.e. it cannot be
revoked unless all the parties ask for a modification; only then, an exception can be made. An
ILOC provides added risk protection for the seller by promising a guarantee from both the buyer's
and the seller's bank.

Confirmed LC
A confirmed LC is one where the advising bank makes additional confirmation at the request of
the issuing bank that payment will be made. Hence the advising bank is equally responsible for
payment. Therefore, the confirming or advising bank must bear the cost if the buyer doesn’t pay
the sum to the beneficiary.
A letter of credit that contains a guarantee on the part of both the issuing and advising banks for
payment to the seller so long as the seller´s documentation is in order and the terms of the letter of
credit are met. Confirmation is only added to irrevocable letters of credit, usually available with
the advising bank. If confirmation of the letter of credit is desired, the applicant must state this
expressly in his/her letter of credit application. The confirming bank assumes the credit risk of the
issuing bank as well as the political and transfer risks of the purchaser´s country. Without
confirmation of the letter of credit, the advising bank will forward the letter of credit to the
beneficiary without taking on its own commitment.

Unconfirmed Letter of Credit

An unconfirmed letter of credit is one which has not been guaranteed or confirmed by any bank
other than the bank that opened it. The advising bank forwards the letter of credit to the beneficiary
without responsibility or undertaking on its part but confirming authenticity.

Transferable letter of credit

A transferable Letter of Credit is a credit facility in which the first beneficiary has the right to pass
on the available credit to another party, i.e., the secondary beneficiary. This is possible only when
the Letter of Credit is marked as transferable by the issuing bank upon the instructions of the buyer
or the importer of goods.
There are four parties involved in it. The parties are the first beneficiary, secondary beneficiary,
final buyer, and the bank. The middlemen/exporter, i.e., the first beneficiary, is one who receives
an order from the final buyer. The middlemen are always in shortage of money. So, he requests
the final buyer for a Transferable Letter of Credit. If the final buyer finds it valuable to engage in
the foreign transaction, he will request his bank to issue an Irrevocable Transferable Letter of
Credit. Now the first beneficiary can purchase the raw materials from the supplier to manufacture
goods. Instead of making a cash payment, the middlemen can pay their supplier by giving him the
Transferable Letter of Credit. Here the supplier becomes the secondary beneficiary.

Back to back LC
Back-to-back letters of credit occur in transactions wherein the seller is guaranteed to receive
payment once the proof that the terms of the transaction have been completed is presented to the
bank (intermediary's bank).

In most cases, no direct interaction occurs between the buyer and the seller. Arrangements are
made by the intermediary on behalf of the buyer. Two distinct letters of credit (LCs) are used in
back-to-back letters of credit.

A back-to-back letter of credit involves two letters of credit to secure financing for a single
transaction. These are usually used in a transaction involving an intermediary between the buyer
and seller. Back-to-back letters of credit are used primarily in international transactions. Back-to-
back letters of credit are actually made up of two distinct LoCs, one issued by the buyer’s bank to
the intermediary and the other issued by the intermediary’s bank to the seller. With the original
LC from the buyer’s bank in place, the broker goes to his own bank and has a second LC issued,
with the seller as the beneficiary.

Red clause LC
The red clause refers to language inserted into the LC by the issuing bank which permits the bank
that receives and accepts the LC on behalf of the beneficiary (i.e. the “nominated bank”) to pay a
percentage of the value of the credit to the beneficiary. Traditionally, since this clause appeared in
bold red type the credit was named ‘red clause’ credit.

By using a red clause LC, the LC beneficiary can request an advance for an agreed amount from
the nominated bank. Such advances are most often intended and used to finance the manufacture
or purchase of the goods to be delivered to the LC applicant who issued the credit. Advances given
against red clause letters of credit are often referred to as “packing credit”. Thus, one can think of
the red clause letter of credit as a financial instrument in which a buyer extends an unsecured loan
to a seller even though it is really the seller’s bank that provides the actual cash by using the
instrument as collateral to secure the loan.

Standby letter of credit

Standby Letter of Credit (SBLC) is a type of letter of credit (LC) where the issuing bank commits
to pay to the beneficiary if the applicant fails to make the payment.

SBLCs, unlike other types of LCs, are a type of contingency plan. In the case of other LCs, the
bank makes the payment first, and then the applicant pays to the bank at a later date. However,
when a bank issues an SBLC, they are only required to make the payment if the buyer or the
applicant defaults.

A standby letter of credit is often required in international trade to help a business obtain a contract.
Since the parties to the contract do not know each other, the letter promotes the seller’s confidence
in the transaction. It is seen as a sign of good faith since it shows the buyer’s credit quality and
ability to make payment for goods or services even if an unforeseen event occurs.

When setting up an SBLC, the buyer’s bank performs an underwriting duty to verify the credit
quality of the buyer. Once the buyer’s bank is satisfied that the buyer is in good credit standing,
the bank sends a notification to the seller’s bank, assuring its commitment of payment to the seller
if the buyer defaults on the agreement. It provides proof of the buyer’s ability to make payment to
the seller.

Major Parties

Applicant’s letter of credit

Applicant is the major party involved in Letter of Credit. Applicant is the party who apply and
opens the LC, buyer of goods. Letter of credit is opened as per his instruction and necessary
payment is arranged to open letter of credit with his bank.
Beneficiary
Beneficiary is the seller of the goods or the provider of the services in a standard commercial letter
of credit transaction. Letter of credit is opened by the issuing bank in favor of the beneficiary.
Beneficiaries will be eligible to receive payment under letters of credit, as long as they make
complying presentations and meet LC conditions.

LC issuing bank
The bank opens a letter of credit on behalf of the applicant (buyer) and forwards it to the advising
bank for delivery to the beneficiary. Issuing Bank is the bank that issues a letter of credit at the
request of an applicant. Issuing bank undertakes to honor a complying presentation of the
beneficiary without recourse which means that issuing banks must pay the letter of credit amount
to the beneficiaries, if complying presentation has been made.

Roles and responsibilities of issuing bank:

• Drafting letter of credit: Issuing bank gather required information from applicant via LC
forms and performa invoice to draft letter of credit.
• Issuance of letter of credit: After gathering necessary data, issuing bank issues letter of
credit. Letter of credit is opened by the issuing bank mostly on behalf of the applicant.
• Checking presentation: Issuing bank checks the documents presented by beneficiary in
order to determine whether presentation is complied or not.
• Payment: If the documents found to be complying then issuing bank makes necessary
arrangement for payment.
• All other banks are acting according to the instructions and authorization that they have
received from the issuing bank.
Advising Bank
A branch or correspondent bank at or near the domicile of the beneficiary, to which the issuing
bank either sends the letter of credit or a notification that a letter of credit has been issued, with
instructions to notify the beneficiary. Advising bank is the bank that advises the credit at the
request of the issuing bank. An advising bank that is not a confirming bank advises the LC and
any amendment without any obligation to honor. By advising the credit or amendment, the
advising bank signifies that it has satisfied itself as to the apparent authenticity of the credit or
amendment and that the advice accurately reflects the terms and conditions of the credit.

Roles and responsibilities of advising bank

• Advising bank is the bank that advises the letter of credit to the beneficiary.
• Advising bank acts at the request of the issuing bank.
• In most cases advising bank and beneficiary locate at the same country which is contrary
to the issuing bank.
• This is why issuing banks use another bank’s services to advice the letter of credit to the
beneficiaries.
• Advising bank has no obligation for payment.
 • A letter of credit can be advised to an exporter via an advising bank.
• According to the letter of credit rules, the advising bank has no payment responsibility
against the exporter as long as the advising bank is not a confirming bank.
• The advising bank advises the letter of credit and any amendment without any undertaking
to honor or negotiate.
• Advising bank has two main responsibilities against the beneficiary. Firstly, the advising
bank must signify that it has satisfied itself as to the apparent authenticity of the letter of
credit or amendment. Secondly, the advising bank must ensure that the advice of the letter
of credit accurately reflects the terms and conditions of the credit or amendment received
from the issuing bank.

Nominated Bank

The bank nominated by the Issuing Bank as being the bank at which the Beneficiary may present
the documents required by the LC and obtain payment. A Bank in exporter’s country which is
specifically authorized by the Issuing Bank to receive, negotiate, etc., the documents and pays the
amount to the exporter under the LC.
The term nominated bank refers to the financial institution that receives payment on behalf of a
beneficiary to a letter of credit. Nominated banks are typically used to facilitate the receipt of
payment when goods or services are provided to the importer.

Roles and responsibilities of nominated bank:

• Nominated Bank is the bank with which the letter of credit is available.
• In some situations issuing banks open letters of credit that is available with any bank in
beneficiaries countries. These kind of letters of credit are known as “freely negotiable l/cs”.
• Nominated bank’s payment obligation is not defined in strict terms.
• Beneficiaries could get their payment from nominated banks with recourse basis.

Confirming Bank
Confirming bank is the bank that adds its confirmation to a credit upon the issuing bank’s
authorization or request. Confirming bank may or may not add its confirmation to a letter of credit.
This decision is up to confirming bank only. Even if the issuing bank fails to honor, confirming
bank must pay to the beneficiary.
The confirming bank provides an additional guarantee to the undertaking of the issuing bank. It
comes into the picture when the exporter is not satisfied with the assurance of the issuing bank or
not satisfied with rating of issuing bank.

A bank which adds its guarantee to the LC opened by another Bank and thereby undertakes
responsibility for payment/acceptance/negotiation/incurring deferred payment under the credit in
addition to that of the Issuing Bank. It is normally a bank operating in the country of the beneficiary
and hence it’s guarantee adds to the acceptability of the LC for the beneficiary. This is being done
at the request / authorization of the Issuing Bank.

Roles and responsibilities of confirming bank

• Confirming bank is the bank that adds its confirmation to a letter of credit.
• Confirming banks could only add their confirmation if the issuing banks authorize them to
do so.
• Confirming bank and nominated bank are expected to be the same bank, although it is not
a necessity according to UCP 600.
• Confirming bank’s payment obligation is defined in strict terms. Beneficiaries could get
their payment from confirming banks without recourse basis.

Reimbursing bank
In letter of credit arrangements, the reimbursing bank is the bank that serves as a source of funds
payment to the beneficiary. Upon presentation of credit conforming documents nominated bank
would need to pay the beneficiary and claim reimbursement from reimbursing bank or issuing
bank. Reimbursing Bank is the settlement bank between the issuing bank and the nominated bank
or the confirming bank.
The reimbursing bank is where the paying account is set up by the issuing bank. The reimbursing
bank honors the claim that settles the negotiation/acceptance/payment coming in through the
negotiating bank.

If letter of credit currency is USD, reimbursing bank is usually located in US. If letter of credit
currency is EUR, reimbursing bank is generally located in Germany.

Roles and responsibilities of reimbursing bank:

• Reimbursing bank is the bank instructed or authorized to provide reimbursement to the
nominated bank or confirming bank.
• Reimbursing banks provide reimbursement to above mentioned banks according to the
reimbursement authorization issued by the issuing bank.
• Reimbursing banks are big and globally reliable financial institutions.

Second Beneficiary

Second beneficiary is one of the other parties involved in Letter of Credit. Second beneficiary who
represent the first beneficiary or original beneficiary in their absence, where in the credits belongs
to original beneficiary is transferable as per terms.

Essential documents in LC
• Firm/Company Registration Certificate
• PAN Certificate
• Board minute (if applicable)
• MOA (Memorandum of Association)
• AOA (Article of Association)
• Latest Tax Clearance Certificate
• LC application form
• BI BI NI form no. 3
• EXIM code (Export Impot code)
• Proforma Invoice/Sales contract
• Harmonic code of the goods as per the Custom Tariff/NRB and incoterm must be mentioned
in Proforma Invoice
• Certificate of Origin
• Certificate of Analysis/inspection
• Transport Documents (Bill of lading/Airway bill/Road Consignment bill)
• Insurance Policy

Internal process to open the LC

• LC limit application
• LC limit approval
• Cash margin as prescribed by the bank
• LC commission and other charges of the bank
• Forward of typing
• Types of LC to be checked by official
• Dispatch

RISK ASSOCIATED WITH LC

Political risk
• In a climate where the world’s financial markets are in turmoil, the assessment of country
risk becomes increasingly important when engaged in international trade transactions.
Political risks in international trade, in simple terms, can be defined as the factors that are
happened outside of importer's or exporter's control, preventing full or part of the payment
of the goods reaching to the exporter or else preventing the delivery of the goods to the
importer.
• Some examples of country risks are riot, civil war, boycott, sovereign risk etc.

Fraud risk
• As export and import transactions occur between companies located in different countries,
the fraud risk in international trade is comparatively higher than the domestic trade.
• Additionally, fraudulent transactions in international trade possess more destructive risks
to the exporters and importers, because of the fact that the volume of international trade
 transactions is generally bigger than domestic sales and also it is very hard to compensate
losses resulted from fraudulent transactions. Fraudulent companies disappear very quickly,
before you can reach them legally.

Foreign exchange risk

• No matter what kind of letter of credit (insight letter of credit or deferred letter of credit),
there is a time distance from issuing a letter of credit to the actual payment for importers.
This long-time distance may cause a big fluctuant in the exchange rate.
• If under the term of letter of credit, there is a time distance from the credit-issuing date to
consignment, and arrival of the document in the issuing bank, fluctuation in exchange rate
will increase cost to the buyer/importer
• In international trade, the longer the time lasts, the more exchange rate risks exist. Once
the exchange rate of paying currency increasing, the importer has to pay more than the
anticipative amount.

Applicant’s risk
• Applicant is the importer in a letter of credit transaction and applicants’ risk can be
classified under shipment risk, issuing bank’s failure risk, fraud risk.
• Shipment risk: short shipment, shipment of under quality goods, late shipment risk falls in
this category
• Failure of issuing bank: Failure of issuing bank may result in payment risk. Incase of the
issuing bank fails to pay LC amount, applicant may have to pay the credit amount to the
beneficiary outside of letter of credit even if applicant paid the amount to the issuing bank.
• Fraud risk: Applicants are exposed to fraud risk that are commonly originated from the acts
of beneficiaries. This scenario becomes reality if beneficiary gets his money from the
confirming or issuing bank against forged documents.
• Exchange rate risk: In international trade, the longer the time lasts, the more exchange
rate risks exist. Once the exchange rate of paying currency increasing, the importer has to
pay more than the anticipative amount.
Beneficiary’s risk
• Beneficiary means the party in whose favor a credit is opened. Beneficiary’s risk under
letter of credit are discrepant document risk, fraud risk, non payment risk.
• Discrepant document risk: If the bank figures it out that the documents are discrepant, then
beneficiary can only reach the payment upon applicant’s acceptance of documents.
• Non payment risk: Beneficiary may not get paid due to bankruptcy of issuing bank. Further
political risk including war, boycott, violence, terrorism may also increases the risk of non
payment to beneficiary.

Risk to bank
• Issuing bank is the entity which gives conditional payment guarantee to the beneficiary.
As issuing bank is more vulnerable to the risks in letter of credit transaction:
 • Insolvency risk of applicant: Issuing bank may not able to recover the credit amount that
has already been paid to beneficiary, if applicant become insolvent after payment has been
made.
• Political risk: Issuing bank may not able to honor its payment obligation due to various
political risk.

Documents under LC

Draft
A draft is a bill of exchange and a legally enforceable instrument which may be regarded as the
formal evidence of debt under a letter of credit. Drafts drawn at sight are payable by the drawee
on presentation. Term (usance) drafts, after acceptance by the drawee, are payable on their
indicated due date.

Commercial Invoice
The commercial invoice is an itemized account issued by the beneficiary and addressed to the
applicant, and must be supplied in the number of copies specified in the letter of credit.

Bill of Lading
A bill of lading is a receipt issued by a carrier for goods to be transported to a named destination,
which details the terms and conditions of transit. In the case of goods shipped by sea, it is the
document of title which controls the physical custody of the goods.
Air Waybill
An air waybill is a receipt issued by an air carrier indicating receipt of goods to be transported by
air and slowing goods consigned to a named party. Being a non-negotiable receipt it is not a
document of title.

Insurance Policy or Certificate

Under the terms of a CIF contract, the beneficiary is obliged to arrange insurance and furnish the
buyer with the appropriate insurance policy or certificate.
The extent of coverage and risks should be agreed upon between the buyer and seller in their
initial negotiations and be set out in the sales contract.
Since the topic of marine insurance is extremely specialized and with conditions varying from
country to country, the services of a competent marine insurance broker are useful and well-
advised.

Packing List
A packing list is usually requested by the buyer to assist in identifying the contents of each
package or container. It must show the shipping marks and the number of each package. It is not
usually required to be signed.
Certificate of Origin
As the name suggests, a certificate of origin certifies as to the country of origin of the goods
described and should comply with any stipulations in the letter of credit as to originating country
and by whom the certificate is to be issued.
The certificate should be consistent with and identified with the other shipping documents by
shipping marks and numbers and must be signed.

Inspection Certificate
When a letter of credit calls for an inspection certificate it will usually specify by whom the
certificate is to be issued; otherwise, the same general comments as in the case of the certificate
of origin apply.
As a preventative measure against fraud or as a means of protecting the buyer against the
possibility of receiving substandard or unwanted goods, survey or inspection certificates issued by
a reputable third party may be deemed prudent.
Such certificates indicate that the goods have been examined and found to be as ordered.