Letter of Credit: How It Works and What a Lender Reads

In a sale between strangers, each side wants the other to perform first. A letter of credit, also called a documentary credit, breaks the stand-off by tying payment to paper that a bank can check. The film above follows one shipment through that sequence. This page follows the file behind it, because the promise that settles the exporter's worry opens a new question for the bank: if it pays, will its customer pay it back?

Once issued, the bank's obligation stands apart from the sale. A quarrel over quality or the buyer's insolvency does not release the bank if the documents comply. That independence is what the exporter is buying, and it is why the bank assesses the importer before it signs anything.

Most credits are issued subject to UCP 600, the International Chamber of Commerce's rules, which apply because the credit says so rather than because a statute does. Under them a credit is irrevocable even if it does not say so. Unless the credit sets another period, original transport documents go in within 21 calendar days of shipment and before expiry. Each bank examining the documents then has up to five banking days to check them on their face, against the credit and one another. They need not be identical but must not conflict, and any refusal goes in one notice listing every discrepancy.

Credits differ in when and how they pay. A sight credit pays once complying documents are presented; a usance credit pays at a stated later date. A confirmed credit adds a second bank's promise. Transferable and back-to-back credits serve traders selling goods they do not make, and a red clause lets the seller draw part before shipment.

A ceramic tile importer, constructed for this page like every figure in it, buys US$600,000 of tiles from a manufacturer abroad under a sight credit. The credit calls for order bills of lading made out to the order of the issuing bank. The importer's bank has approved a US$2.0m trade limit, shared between open credits and import loans, and takes cash cover of 15% on this credit. The limit and the cover are the example's, not market norms.

Apart from the cash cover, no money has moved. The bank carries US$600,000 as a contingent liability, off its balance sheet, and the importer's borrowings do not change. The bank still counts the full amount against the limit, because complying documents will oblige it to pay.

The exporter's documents arrive on the last of the 21 days. The invoice says "porcelain tiles" where the credit says "glazed porcelain floor tiles, 600 × 600 mm", and no time remains to correct and re-present it. The bank gives notice of refusal and asks the importer whether it will waive the discrepancy. A waiver is the importer's to offer and the bank's to accept: had trading been weakening, the bank would have been choosing to pay money it no longer had to. Trading is sound, the waiver is accepted, and payment comes twelve days later than a clean presentation would have brought it.

Payment did not end the exposure; it changed its form. Borrowings rose by US$510,000 in a day with nothing new in the business, and the limit recovered only by the cash cover. The rest returns when the tiles are sold and the loan repaid, and the bank will release the bills against a trust receipt so that can happen.

A documentary collection moves the same kind of paper through banks acting only as agents, so no bank takes on the payment. A bank guarantee is a fallback for non-performance where a credit is the intended means of payment, and a standby letter of credit does a guarantee's work in a credit's form.

The difference can reach bank capital. The Basel standardised approach applies a 20% credit conversion factor to short-term, self-liquidating trade letters of credit, 50% to transaction-related items such as performance bonds, and 100% to direct credit substitutes such as general guarantees of indebtedness. Each regulator sets its own version: Australia's APS 112 has those three factors, while the PRA's Basel 3.1 rules, in force from 1 January 2027, give performance bonds the same 20% as a trade credit.

DEFINED IN ONE PARAGRAPH → · BANK GUARANTEE VS LETTER OF CREDIT → · WHAT A LENDER READS IN THE BILL →

On the importer's file, open credits are a forward view of debt. A rising book can mean growth or stock the business cannot sell, and an open credit may reach the accounts only as a note, if at all, so the bank's limit report is the better record. Whether it counts as debt turns on the document: many facility agreements bring the reimbursement obligation into financial indebtedness, while some leverage definitions leave undrawn trade instruments out. Cash cover lowers the bank's exposure by exactly what it takes from the importer's liquidity.

On the exporter's file the reading runs the other way. The risk has moved to the issuing bank and its country, so the lender asks whether that bank is sound, whether its own limits have room for that name, and whether the country can make foreign-currency payments. Confirmation adds a name the lender knows. LC discounting comes later, once a bank has accepted complying documents under a usance credit.

A discrepancy is where the two readings meet. An ICC briefing in 2022 estimated that 65% to 80% of documents presented under credits worldwide are refused the first time, so a clean record is evidence about a back office. In the example, at an illustrative 8% a year:

The interest is the small part. For those twelve days the receivable rested on a buyer's waiver, not a bank's promise, and a lender counting it as bank risk had the wrong name on the file.

PAID LATER: THE USANCE CREDIT → · THE SECOND PROMISE → · AFTER THE BANK HAS PAID →