Letter of credit and its operation procedures in banks

A TERM PAPER
ON

LETTER OF CREDIT AND ITS OPERATION

PROCEDURES IN BANKS

Course code: FB-509

Course Title: Principles and Practices of Banking

SUBMITTED TO
Abdullah Al Mahmud
Lecturer
Department of Banking
Faculty of Business Studies
University of Dhaka
[Submitted for the partial fulfillment of the requirements of the degree in Master of
Business Administration (Banking)]

PREPARED AND SUBMITTED BY

Md. Ataur Rahman ID: 50917063
Md. Abu Zamih ID: 50917063
Md. Abul Kalam Azad ID: 50815012
Ms. Rukshana Alam ID: 50917066

Submission Date: July 22, 2010

University of Dhaka
Department of Banking

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 Letter of credit and its operation procedures in banks

Chapter I

INTRODUCTION

Letter of Credit (L/C) is a very important issue of foreign exchange management because
without L/C import and export cannot be possible. Importer and Exporter do not know
each other. For this reason settlement of payment cannot be possible without the
arrangement of Bank particularly in foreign trade. Therefore import/Export also cannot
be possible if no L/C can be made through Bank. So L/C is a very important issue in
foreign trade.

L/C is a guarantee of a bank (Issuing Bank) on behalf of the importer in a trade in favor
of the exporter to pay a certain sum of money under some specific terms and conditions.
So, an L/C is a negotiable instrument (A form of documentary credit) that carries a
promise of payment with the fulfillment of certain conditions. An L/C can be used in
foreign trade as well as for local payments.

While a letter of credit is issued for a guarantee in a specific transaction, a standby letter
of credit is a general letter providing a guarantee for a specific period of time. Most
letters of credit are irrevocable, but occasionally a letter of credit is revocable; that is, it
can be canceled by the bank without notifying the beneficiary.

So it is very important for every business people and all concerned to know what the
letter of credit is, how it works and how it helps in international trade. Keeping in mind
the above stated fact the present study was taken to cover the following aspects:

i. Helps to know all about of a letter of credit.

ii. How letter credit works in international trade payment.

iii. How a third party i.e., the bank can help in export and import business.

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 Letter of credit and its operation procedures in banks

Chapter II

DESCRIPTION

2. LETTER OF CREDIT AND ITS OPERATION PROCEDURES IN BANKS:

2.1 OPENING WORDS:

One of the important functions of commercial banks is to finance import and export
trades. In international trade, because of distance involved, buyers and sellers do not
know each other. It is difficult for them for appreciate each others integrity and credit
worthiness, and, apart from this, it is also difficult to know various regulations prevailing
in their respective countries regarding imports and exports. Thus, the buyer wants to be
assured of goods and the seller to be assured of payments. Commercial banks, therefore,
assure these things to happen simultaneously by opening letter of credit guaranteeing
payment to seller and delivery of goods to buyer. By opening a letter of credit on behalf
of a buyer in favor of a seller, commercial bank undertakes to make payment to a seller
subject to submission of documents drawn in strict compliance with letter of credit terms
giving title of goods to the buyer. It is a conditional guarantee. The letter of credit, thus,
constitutes one of the most important methods of financing foreign trade.

In fact a letter of credit carries a promise or an undertaking by the issuing banker which
is valued and honored on a global basis. Similarly, the buyer is interested that he gets
possession of goods before he pays for them and he is able to make sure that the goods
are exactly those he ordered. It is important to decide in advance how a seller is going to
get payment before handling over possession of goods and how the buyer is going to get
constructive possession of the goods before making payment. This is more so because
the parties are located in two different countries separated by distance, with different
political, legal, monetary and trading system and possibly without knowing each other
well. The two trading partners wish to reconcile the conflicting interests and converging
them into one acceptable solution. This object led to research for a system which is
mutually convenient, reliable and safe, taking into account their own individual
problems, apprehensions and requirements.

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 Letter of credit and its operation procedures in banks

The solution resulted in the evolution of Documentary Credit method where a bank acts
as a fiduciary delivery of goods by the seller to the buyer and payment being made by the
buyer on presentation of documents complying with the terms and conditions of the
credit.

2.2 LETTER OF CREDIT:

A letter of credit is a document issued by a bank which provides a guarantee of funding
for a business. Letters of credit are used particularly in overseas transactions, where a
company in one country wishes to purchase goods or services from a company in another
company. The bank reviews the buyer's credit and provides a guarantee of payment in
case of default by the buyer. The person receiving the letter of credit is considered the
"beneficiary."

A letter of credit may be a commercial or non-commercial one. When it relates to a

mercantile transaction, i.e., buying and selling of goods, it is called a commercial letter
of credit. When it does not relate to any mercantile transaction but only conveys an order
of opening banker to his overseas correspondent to pay to a third party named in the
order within a specified period of time, against drafts drawn upon him by that party upto
a stated amount, it is non-commercial, and is called circular letter of credit.

A commercial credit may be clean or documentary. If the letter undertakes to honor bills
without conditions, it is called a clean letter of credit. If in a commercial letter of credit
the banker undertakes to honor bills drawn under it only on tender of the documents of
title to the goods to which such bills relate, such as, bill of lading and other shipping
documents, the letter is called a Documentary Letter of Credit, or simply “Documentary
Credit”. A letter of Credit or Documentary Credit is an arrangement whereby the
obligation to pay to the supplier is undertaken by the bank.

Documentary credits therefore

 are an arrangement by banks for settling international commercial transactions.

 provide a form of security for the parties involved.

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 Letter of credit and its operation procedures in banks

 ensure payment provided that the terms and conditions of the credit have been
fulfilled.

 mean that payment by such means is based on documents only, and not on
merchandise or services involved.

2.3 ELEMENTS OF A LETTER OF CREDIT:

• A payment undertaking given by a bank (issuing bank)

• On behalf of a buyer (applicant)
• To pay a seller (beneficiary) for a given amount of money
• On presentation of specified documents representing the supply of goods
• Within specified time limits
• Documents must conform to terms and conditions set out in the letter of credit
• Documents to be presented at a specified place

2.4 TYPES OF COMMERCIAL LETTER OF CREDITS:

We can divide L/Cs into two broad categories.

Revocable L/C

The terms and conditions of L/C can be changed at any time without the consent of or
notice of the beneficiary. In case of seller (Beneficiary) revocable credit involves risk. A
revocable credit may be amended or cancelled by the issuing bank prior notice to the
beneficiary. On the other hand revocable credit gives the buyer maximum flexibility.
This kind of L/C does not exist in our country.

Irrevocable L/C

The terms and conditions of L/C cannot be changed. This kind of L/C exists in
Bangladesh. It is a definite undertaking of the issuing Bank, provided that the stipulated
documents are presented to the nominated Bank. Once this commitment has been entered
into, the bank cannot disown its responsibility without the agreement of the beneficiary.
A unilateral amendment or cancellation, as in the case of a revocable credit is not
possible in case irrevocable, unconfirmed credit. Since under the documentary credit a
debt relationship exists only between the issuing bank and beneficiary, it is advisable to

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 Letter of credit and its operation procedures in banks

assess the issuing banks standing as well as the sovereign and transfer risk of the country
involved.

Types of documentary credits according to payment methods

Sight Payment Credit

The payment is made as soon as documents shown to the issuing Bank and payment
received from importer. Instruction is given to reimbursing bank to give payment.

Deferred Payment Credit

The payment of this kind of L/C is made after 30, 60, 90, 120 or 180 days soon as
documents shown to the issuing Bank. The credit with deferred payment differs only
slightly in its effect on the beneficiary from the credit with time draft. It is also called
USANCE L/C.

Special types of Documentary Letter of credit

Revolving Credit

A Revolving credit is one where under the terms and conditions thereof the amount of
the credit is renewed or reinstated without specific amendment to the credit being
needed. It can revolve in relation to time or value. But credit the revolves in relation to
value is not in common use.

Back to Back Credit

Another special type of L/C is issued in Bangladesh that is called Back-to-Back (B to B)

L/C where the applicant opens an L/C against another export L/C. These B to B L/Cs are
USANCE L/Cs.

2.5 IN AN L/C CYCLE, THE FOLLOWING ARE THE COMMON PARTIES

Importer: The party that imports goods, also knows as applicant, buyer, consignee.

Exporter: The party that sells or export goods, also known as seller, beneficiary.

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 Letter of credit and its operation procedures in banks

Issuing Bank: The Importer’s bank that issues the L/C. It is also called L/C opening
Bank.

Advising Bank:

The responsibility of this Bank is –

 To authenticate the issuing Bank

 Verbally tells the exporter that the Advising Bank cannot authenticate the issuing
Bank but the exporter is well known to the advising bank. Issuing bank must have a
BKE (Bilateral Key Exchange) arrangement with the advising bank.

Negotiating Bank: The bank that the Exporter after receiving the L/C negotiates it along
with other documents for receiving the proceeds from the issuing bank.

Add Confirming Bank: Being suspicious about the payment, sometimes the exporter
may ask for confirmation of the payment from a bank of his own country – a bank giving
such confirmation is called confirming bank that takes a confirmation charge from the
issuing bank.

Reimbursement Bank: This is the bank that the L/C issuing bank maintains its nostro
account with. Upon instruction from the Issuing Bank, the reimbursement bank makes
transfer of funds to the negotiating bank.

2.6 ADVANTAGES OF A LETTER OF CREDIT TO THE BENEFICIARY:

A letter of credit is an instrument, which facilitates trade transactions between two

parties who are not known to each other. The major advantages derived by the seller or
the beneficiaries of a letter of credit are as follows:

1) Certainty of payment and avoidance of risk – Though the exporter may be quite
unfamiliar with the importer, the letter of credit provides him an absolute assurance
that the bills of exchange drawn under the letter of credit will be honored.

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 Letter of credit and its operation procedures in banks

2) Immediate negotiation of the bills is possible under letter of credit – Bills drawn
under the letter of credit are readily negotiated by the advising/confirming banker or
any other banker, because of the firm undertaking given by the opening banker.
The seller (or exporter) is able to realize the amount of the bill immediately by
negotiating it with any banker.
3) Security against Exchange Restriction – The opening banker issues a letter of credit
after having been satisfied that the exchange control regulates of his own country do
not impose any restriction on the transfer of money for the purpose in question. The
availability of necessary foreign exchange in the importer’s country for honoring the
bill is taken for granted. The transfer risks are thus avoided and the exporter need not
investigate into the foreign exchange regulations in the importer’s country.
4) Advance may be obtained – The exporter may obtain an advance from the bank on
the basis of a letter of credit for the purpose of procuring and processing or
manufacturing the goods to be exported.

2.7 ADVANTAGES OF LETTER OF CREDIT TO THE BUYER:

1) The issuing banker lends the benefit of his own credit to the importer, who is enabled
to import the good which is otherwise not possible.
2) The letter of credit gives an assurance to the importer that the bills of exchange
drawn under the letter of credit will be honored only when they are strictly in
accordance with the conditions laid down in the letter of credit and the documents
required therein are duly enclosed.

2.8 MECHANISM OF LETTER OF CREDIT:

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 Letter of credit and its operation procedures in banks

The following diagram brings out clearly the operation of letter of credit.

Contract of
Sale
(1)

Exporter Ships Importer

London Goods to Dhaka
(Beneficiary) (5) (Applicant)

Forwards Presents Docs Recovers Amount Applies for

L/C to (4) and Obtains From and opening of
Payment from Deliver Docs L/C
(6) (8) (2)

Midland Bank Sent Docs Modern Bank

London Advising and Obtains Dhaka (Issuing
/ Negotiating Reimbursement Bank)
bank (7)

Opens L/C and

sends it to
(3)

Fig 01: Diagrammatic representation of the operation of letter of credit

2.9 AVAILABILITY:

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 Letter of credit and its operation procedures in banks

A letter of credit being an irrevocable undertaking of the issuing bank makes available
the Proceeds, to the Beneficiary of the Credit provided, stipulated documents strictly
complying with the provisions of the letter of credit, UCP 600 and other international
standard banking practices, are presented to the issuing bank, then:

• i.if the Credit provides for sight payment – by payment at sight against compliant
presentation
• ii.if the Credit provides for deferred payment – by payment on the maturity date(s)
determinable in accordance with the stipulations of the Credit; and of course
undertaking to pay on due date and confirming maturity date at the time of compliant
presentation
• iii.a.if the Credit provides for acceptance by the Issuing Bank – by acceptance of
Draft(s) drawn by the Beneficiary on the Issuing Bank and payment at maturity of
such tenor draft, or
• iii.b. if the Credit provides for acceptance by another drawee bank – by acceptance
and payment at maturity Draft(s)drawn by the Beneficiary on the Issuing Bank in the
event the drawee bank stipulated in the Credit does not accept Draft(s) drawn on it,

or by payment of Draft(s) accepted but not paid by such drawee bank at maturity;

• iv. if the Credit provides for negotiation by another bank – by payment without
recourse to drawers and/or bona fide holders, Draft(s) drawn by the Beneficiary
and/or document(s) presented under the Credit, (and so negotiated by the nominated
bank )

• Negotiation means the giving of value for Draft(s) and/or document(s) by the bank
authorized to negotiate, viz the nominated bank. Mere examination of the documents
and forwarding the same to the letter of credit issuing bank for reimbursement,
without giving of value / agreed to give, does not constitute a negotiation.

2.10 SOME OF THE DOCUMENTS CALLED FOR UNDER A LETTER OF CREDIT:

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 Letter of credit and its operation procedures in banks

• Financial Documents

Bill of Exchange, Co-accepted Draft

• Commercial Documents

Invoice, Packing list

• Shipping Documents

Transport Document, Insurance Certificate, Commercial, Official or Legal

Documents

• Official Documents

License, Embassy legalization, Origin Certificate, Inspection Certificate,

Phytosanitary certificate

• Transport Documents

Bill of Lading (ocean or multi-modal or Charter party), Airway bill, Lorry/truck

receipt, railway receipt, CMC Other than Mate Receipt, Forwarder Cargo
Receipt, Deliver Challan...etc

• Insurance documents

Insurance policy, or Certificate but not a cover note.

2.11 LEGAL PRINCIPLES GOVERNING DOCUMENTARY CREDITS:

One of the primary peculiarities of the documentary credit is that the payment obligation
is abstract and independent from the underlying contract of sale or any other contract in
the transaction. Thus the bank’s obligation is defined by the terms of the credit alone,
and the sale contract is irrelevant. The defences of the buyer arising out of the sale
contract do not concern the bank and in no way affect its liability. Article 4(a) UCP
states this principle clearly. Article 5 the UCP further states that banks deal with
documents only, they are not concerned with the goods (facts). Accordingly, if the

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 Letter of credit and its operation procedures in banks

documents tendered by the beneficiary, or his or her agent, appear to be in order, then in
general the bank is obliged to pay without further qualifications.

The policies behind adopting the abstraction principle are purely commercial and reflect
a party’s expectations: firstly, if the responsibility for the validity of documents was
thrown onto banks, they would be burdened with investigating the underlying facts of
each transaction and would thus be less inclined to issue documentary credits as the
transaction would involve great risk and inconvenience. Secondly, documents required
under the credit could in certain circumstances be different from those required under the
sale transaction; banks would then be placed in a dilemma in deciding which terms to
follow if required to look behind the credit agreement. Thirdly, the fact that the basic
function of the credit is to provide the seller with the certainty of receiving payment, as
long as he performs his documentary duties, suggests that banks should honour their
obligation notwithstanding allegations of misfeasance by the buyer. Finally, courts have
emphasised that buyers always have a remedy for an action upon the contract of sale, and
that it would be a calamity for the business world if, for every breach of contract between
the seller and buyer, a bank were required to investigate said breach.

The “principle of strict compliance” also aims to make the bank’s duty of effecting
payment against documents easy, efficient and quick. Hence, if the documents tendered
under the credit deviate from the language of the credit the bank is entitled to withhold
payment even if the deviation is purely terminological.

2.12 LEGAL BASIS FOR LETTERS OF CREDIT

Although documentary credits are enforceable once communicated to the beneficiary, it

is difficult to show any consideration given by the beneficiary to the banker prior to the
tender of documents. In such transactions the undertaking by the beneficiary to deliver
the goods to the applicant is not sufficient consideration for the bank’s promise because
the contract of sale is made before the issuance of the credit, thus consideration in these
circumstances is past. In addition, the performance of an existing duty under a contract
cannot be a valid consideration for a new promise made by the bank: the delivery of the
goods is consideration for enforcing the underlying contract of sale and cannot be used,
as it were, a second time to establish the enforceability of the bank-beneficiary relation.

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 Letter of credit and its operation procedures in banks

Legal writers have failed to satisfactorily reconcile the bank’s undertaking with any
contractual analysis. The theories include: the implied promise, assignment theory, the
novation theory, reliance theory, agency theories, estoppels and trust theories,
anticipatory theory, and the guarantee theory. Davis, Treitel, Goode, Finkelstein and
Ellinger have all accepted the view that documentary credits should be analyzed outside
the legal framework of contractual principles, which require the presence of
consideration. Accordingly, whether the documentary credit is referred to as a promise,
an undertaking, a chose in action, an engagement or a contract, it is acceptable in English
jurisprudence to treat it as contractual in nature, despite the fact that it possesses
distinctive features, which make it sui generis.

A few countries including the US (see Article 5 of the Uniform Commercial Code) have
created statutes in relation to the operation of letters of credit. These statutes are designed
to work with the rules of practice including the UCP and the ISP98. These rules of
practice are incorporated into the transaction by agreement of the parties. The latest
version of the UCP is the UCP600 effective July 1, 2007. The previous revision was the
UCP500 and became effective on 1 January 1994. Since the UCP are not laws, parties
have to include them into their arrangements as normal contractual provisions.

2.13 RISK SITUATIONS IN LETTER-OF-CREDIT TRANSACTIONS

Fraud Risks

• The payment will be obtained for nonexistent or worthless merchandise against

presentation by the beneficiary of forged or falsified documents.
• Credit itself may be forged.

Sovereign and Regulatory Risks

• Performance of the Documentary Credit may be prevented by government action

outside the control of the parties.

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 Letter of credit and its operation procedures in banks

Legal Risks

• Possibility that performance of a Documentary Credit may be disturbed by legal

action relating directly to the parties and their rights and obligations under the
Documentary Credit

Force Majeure and Frustration of Contract

• Performance of a contract – including an obligation under a Documentary Credit

relationship – is prevented by external factors such as natural disasters or armed
conflicts

Risks to the Applicant

• Non-delivery of Goods
• Short Shipment
• Inferior Quality
• Early /Late Shipment
• Damaged in transit
• Foreign exchange
• Failure of Bank viz Issuing bank / Collecting Bank

Risks to the Issuing Bank

• Insolvency of the Applicant

• Fraud Risk, Sovereign and Regulatory Risk and Legal Risks

Risks to the Reimbursing Bank

• no obligation to reimburse the Claiming Bank unless it has issued a

reimbursement undertaking.

Risks to the Beneficiary

• Failure to Comply with Credit Conditions

• Failure of, or Delays in Payment from, the Issuing Bank
• Credit Issued by Party other than Bank

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 Letter of credit and its operation procedures in banks

Risks to the Advising Bank

• The Advising Bank’s only obligation – if it accepts the Issuing Bank’s

instructions – is to check the apparent authenticity of the Credit and advising it to
the Beneficiary

Risks to the Nominated Bank

• Nominated Bank has made a payment to the Beneficiary against documents that
comply with the terms and conditions of the Credit and is unable to obtain
reimbursement from the Issuing Bank

Risks to the Confirming Bank

• If Confirming Bank’s main risk is that, once having paid the Beneficiary, it may
not be able to obtain reimbursement from the Issuing Bank because of insolvency
of the Issuing Bank or refusal of the Issuing Bank to reimburse because of a
dispute as to whether or not payment should have been made under the Credit

Other Risks in International Trade

• A Credit risk is a risk from change in the credit of an opposing business.

• An Exchange risk is a risk from a change in the foreign exchange rate.
• A Force majeure risk is 1. a risk in trade incapability caused by a change in a
country's policy, and 2. a risk caused by a natural disaster.
• Other risks are mainly risks caused by a difference in law, language or culture. In
these cases, the cargo might be found late because of a dispute in import and
export dealings.

2.14 OPENING OF LETTER OF CREDIT:

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 Letter of credit and its operation procedures in banks

Import section of any bank deals with L/C opening and post import financing i.e. LIM &
LTR. Now the procedure from opening L/C to disbursement against L/C is given below.

Application for Opening L/C:

At first, an importer will request banker to open L/C along with the following
documents.

1. An application
2. Indent or Performa Invoice
3. Import Registration Certificate (IRC)
4. Taxpayer Identification Number (TIN)
5. Insurance cover note with money receipt
6. A bank account.
7. Membership of chamber of commerce

Indent or Performa Invoice:

Indent or Performa invoice is the sale contract between seller and buyer in import-export
business. There is slight difference between indent and Performa invoice. The sales
contract, which is direct correspondence between importer and exporter, is called
Performa invoice. There is no intermediary between them. On the other hand, there may
be an agent of exporter in importer’s country. In this regard, if the sale contract is
occurred between the agent of exporter and importer then it is called indent.

Delivered Forms by Banker to Importer:

After scrutinizing above-mentioned documents carefully, officer delivers the following

forms to be filled up by importer and banker should check:

Whether the goods to be imported is permissible or not.

Whether the goods to be imported is demandable or not.

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 Letter of credit and its operation procedures in banks

The forms are:

• Import Mercendised Permit Form (IMP).
• L/C Application Form (L/CAF).
• L/C Authorization Form (L/CAF).

Preparation of L/C by Banker:

Bank’s officer prepares L/C when above mentioned forms are to be submitted by
customer or importer. Before preparing L/C bank officer scrutinizes the application in
the following manner.

 The terms and conditions of the L/C must be complied with UCPDC 600 and
Exchange Control & Import Trade Regulation.
 Eligibility of the goods to be imported.
 The L/C must not be opened in favor of the importer.
 Radioactivity report in case of food item.

Survey reports or certificate in case of old machinery is required. Bank of the importer is
called ‘L/C Issuing Bank’. Then issuing bank inform it’s corresponding bank, called
“Advising Bank’ or ‘Confirming Bank” located in exporter’s country to advice and the
credit forward to the exporter and simultaneously officer makes L/C opening vouchers.

Desk Work:

 One debit voucher to be passed.

 Corresponding credit voucher to be passed (Margin, commission, postage, stamp,
F.C.C. and others).
 Liability voucher to be passed.

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 Letter of credit and its operation procedures in banks

Accounting treatment:

L/C Applicants A/C or Customer’s A/C Dr.

Margin A/C Cr.
Commission A/C Cr.
VAT on Commission A/C Cr.
Postage A/C Cr.
Stamp A/C Cr.
F.C.C. (foreign corresponding charge) A/C Cr.
Telex charge A/C Cr.

Other A/C Cr.

Customer’s liability A/C Dr.

Banker’s liability A/C Cr.

Forwarding Documentary Credit by Advising or Confirming Bank:

There are usually two banks involved in a documentary credit operation. The issuing
bank and the 2nd bank, the advising bank, is usually a bank in the seller’s country. The
issuing bank asks another bank to advise or confirm the credit. If the 2nd bank
is simply “advice or credit”, it will mention that when it forwards the credit to seller,
such a bank is under no commitment or obligation to pay the seller.

If the advising bank is also “confirming the credit”, this mention that the confirming
bank, regardless of any other consideration, must pay accept or negotiate without
recourse to seller. Then the bank is confirming bank.

Submission of Necessary Documents by Exporter to the Negotiating Bank:

As soon as the seller / exporter receives the credit and is satisfied that he can meet its
terms and conditions, he is in position to load the goods and dispatch them. The seller

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 Letter of credit and its operation procedures in banks

then sends the documents evidencing the shipment to the bank.

Exporter will submit those documents in accordance with the terms and conditions as
mentioned in L/C. Generally the documents observed by me in the foreign exchange
department are:

o Bill of exchange
o Commercial invoice
o Bill of lading
o Certificate of origin
o Packing list
o Clean report of finding (CRF)
o Weight list
o Insurance cover note
o Pre-shipment certificate

SOME RELEVENT DEFINITIONS

Bill of Exchange:

According to the section 05, Negotiable Instruments (NI) Act, unconditional order signed
by the maker, directing a certain person to pay [on or to the order of a certain person or
to the bearer of the instrument. It may be either at sight or certain day sight. At sight
means making payment whenever documents will reach in the issuing bank.

Commercial Invoice:

Commercial Invoice issued by exporter is the accounting document by which the seller
charges the goods to buyer.

Bill of lading:

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 Letter of credit and its operation procedures in banks

A bill of lading is a document usually stipulated in a credit when exporter dispatches the
goods. It is an evidence of a contract of carriage, is a receipt for the goods and is a
document of title to goods. It also constitutes a document that is or may be, needed to
support an insurance claim.

The Documents Sent to the Issuing Bank through the Negotiating Bank:

The negotiating bank carefully checks the documents provided by the exporter against
the credit, and if the documents meet all the requirement of the credit, the bank will pay,
accept, or negotiate in accordance with the terms and conditions of the credit. Then the
bank sends the documents to the L/C opening bank.

Common Defects in Documentation:

About half of all drawings presented contain discrepancies. A discrepancy is an

irregularity in the documents that causes them to be in non-compliance to the letter of
credit. Requirements set forth in the letter of credit cannot be waived or altered by the
issuing bank without the express consent of the customer. The beneficiary should prepare
and examine all documents carefully before presentation to the paying bank to avoid any
delay in receipt of payment. Commonly found discrepancies between the letter of credit
and supporting documents include:

• Letter of Credit has expired prior to presentation of draft.

• Bill of Lading evidences delivery prior to or after the date range stated in the
credit.
• Stale dated documents.
• Changes included in the invoice not authorized in the credit.
• Inconsistent description of goods.
• Insurance document errors.
• Invoice amount not equal to draft amount.
• Ports of loading and destination not as specified in the credit.
• Description of merchandise is not as stated in credit.
• A document required by the credit is not presented.

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 Letter of credit and its operation procedures in banks

• Documents are inconsistent as to general information such as volume, quality,

etc.
• Names of documents not exact as described in the credit. Beneficiary information
must be exact.
• Invoice or statement is not signed as stipulated in the letter of credit.

When a discrepancy is detected by the negotiating bank, a correction to the document

may be allowed if it can be done quickly while remaining in the control of the bank. If
time is not a factor, the exporter should request that the negotiating bank return the
documents for corrections.

If there is not enough time to make corrections, the exporter should request that the
negotiating bank send the documents to the issuing bank on an approval basis or notify
the issuing bank by wire, outline the discrepancies, and request authority to pay.
Payment cannot be made until all parties have agreed to jointly waive the discrepancy.

Making the Payment of Foreign Bill through the Reimbursing Bank:

The L/C issuing bank getting the documents checks immediately and if they are in order
and meet the credit requirements, it will arrange to make payment against L/C through
reimbursement bank and will send the importer the document arrival notice.

But if there is any discrepancy in the documents, the L/C issuing bank send message to
the negotiating bank to rectify it under its risks and responsibilities.

2.15 POST-IMPORT FINANCING:

If there is no available in cash in importer’s hand, he can rrequest the bank to grant loan
against the documents for the purpose of post import finance. There are two following
forms of post import finance available.

 LIM (Loan against imported merchandise).

 LTR (Loan against trust receipt).

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 Letter of credit and its operation procedures in banks

On the arrival of goods and lodgment of import documents, importer may request the
bank for clearance of goods from the port (custom) and keep the same to bank godown.
Proper sanction from the competent authority is to be obtained before clearance of
consignment. For giving these types of loan, officer makes loan proposal and sends it to
H/O for approval. After getting approval from H/O, bank grants loan in the form of
either LTR or LIM.

Accounting treatment:

LIM/LTR creation:

LTR/LIM (Importer) A/C Dr.

PAD A/C Cr.

After payment of the loan or delivery of goods:

Party’s A/C Dr.

LTR/LIM A/C Cr.
Interest A/C Cr.

By and large, it is mentioned herewith that bank only deals with the documents, not with
goods & services in case of foreign exchange business.

2.16 A CASE STUDY (PRACTICAL L/C OPERATION PROCEDURE)

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 Letter of credit and its operation procedures in banks

M/S Popular Computer a composite limit holder of Al-Arafah Islami Bank Ltd. M/S
Popular Computer was operating its business locally in the ICT sector in Bangladesh
since 1997. In 2009, Mr. Nasiruddin, proprietor of M/S Popular Computer, wants to
import computer and its accessories from China. In this regard he contacted over
internet with a computer hardware exporting company in China named TNN Pacific
(Pte.) Ltd. After fruitful discussion, they were agreed to create a business relationship
and signed a contract regarding this. M/S Popular Computer collected a proforma
invoice from TNN Pacific (Pte.) Ltd. and came to our bank premises to open a L/C
favoring TNN Pacific (Pte.) Ltd., China to 1000 pcs Computer Monitor. Total price was
USD. 48000. Now the roles played by the bankers are as follows:

Submission of Required Documents by the Importer:

When Mr. Nasiruddin, proprietor of M/S Popular Computer, came to the banker, the
banker said him that you have to submit the following documents
a) IRC (Import Registration Certificate)
b) Trade License
c) VAT Certificate
d) TIN Certificate
e) Membership Certificate from the concerned authority
f) Proforma Invoice
g) Application to the Branch Manager
h) Credit Report of TNN Pacific (Pte.) Ltd.
Then the M/S Popular Computer provided all the above mentioned documents to the
banker.

L/C Margin Development:

After receiving the above necessary documents, the banker discussed with the importer
about the security against the L/C. After discussion, M/S Popular Computer and the
banker came into an agreement that it has to give 20% of the L/C value as cash security
i.e., margin. The L/C value was USD. 48000 equivalent Tk. 33,12,000/= ($1 = Tk.
69.00). The 20% margin of Tk. 33,12,000/= stands at Tk. 6,62,400/=. The L/C
commission and other charges of the bank stands at Tk. 15000/=

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 Letter of credit and its operation procedures in banks

Now the importer deposited total Tk. 6,77,400/= (margin Tk. 6,62,400/= + commission
along with other charges Tk. 15000/=) in his current account maintained with the bank.

Taking Charge Documents from the Importer:

M/S Popular Computer wants to open a sight L/C under commercial sector favoring
TNN Pacific (Pte) Ltd. Now the importer has to sign all the charge documents supplied
by the bank.
 The charge documents comprise of the following:
 Demand Promissory Note (DP Note)
 Demand Promissory Delivery Letter
 Letter of Credit Application Form
 Letter of Credit Authorization Form for Commercial Importer (LCAF)
 Import Form (IMP Form)
 Letter of Guarantee (Personal Guarantee)
After receiving the signed charge documents from the importer then the banker collected
CIB report of M/S Popular Computer from Bangladesh Bank. It was found that the
importer has no overdue liability in other banks.

Insurance of Merchandise for Risk Coverage:

M/S Popular Computer collected Marine Insurance Cover Note from Islami Commercial
Insurance Co. Ltd.

Opening of L/C:
After completing all the above mentioned formalities, the bank has opened a sight L/C
for USD. 48000 favoring TNN Pacific (Pte.) Ltd., China through SWIFT. The latest date
of shipment was 30/05/10.

L/C sent to the Advising Bank:

The advising bank mentioned in the L/C was Standard Chartered Bank (SCB), Shanghai,
China. After getting the L/C the SCB, Shanghai advised the L/C to TNN Pacific (Pte)
Ltd. (exporter).

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 Letter of credit and its operation procedures in banks

Shipment:
After receiving the L/C, TNN Pacific (Pte) Ltd. manufactured the goods and shipped the
goods within 30/05/10 through shipping line named Hanjin Shipping Lines Ltd. The
Hanjin Shipping Lines Ltd. issued the Bill of Lading.

Negotiation:
The exporter prepared all the following documents
 Bill of Exchange
 Commercial Invoice
 Packing List
 Bill of Lading
 Certificate of Origin
 Shipment Advice
After preparing all the documents, the exporter presented the documents at the counter of
HSBC, Shanghai for negotiation. The HSBC, Shanghai acted as a Negotiating Bank of
the exporter. After scrutinizing the documents the HSBC found that docs are complied
with L/C terms and conditions. The HSBC, Shanghai negotiate the docs and sent it to the
L/C issuing bank i.e., Al-Arafah Islami Bank Ltd. for payment.

Payment:
The issuing bank scrutinized the documents and found that the document is fully
complied as per L/C terms and conditions. Now the issuing bank intimated the importer
i.e., M/S Popular Computer that we have received the documents against your L/C and
document is discrepancy free document.

Then the importer took the delivery of documents after making payment for the
remaining L/C value. After receiving the full amount from the importer, the issuing bank
deliver the documents to the importer.

Then the issuing bank made payment to the negotiating bank within five working days
by issuing a payment instruction to SCB, New York.

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 Letter of credit and its operation procedures in banks

Reimbursement:
The issuing bank issued payment instruction as per payment instruction of negotiating
bank to SCB, New York in which the issuing bank, Al-Arafah Islami Bank Ltd.,
maintained a NOSTRO account and the SCB, New York played the role of reimbursing
bank.

After receiving payment instruction from Al-Arafah Islami Bank Ltd. the SCB, New
York debit the NOSTRO account of Al-Arafah Islami Bank Ltd. and made payment to
the negotiating bank i.e., HSBC, Shanghai. In this way, the negotiating bank received
their payment against the L/C.

These are all about a case of Al-Arafah Islami Bank Ltd. regarding a L/C operation.

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 Letter of credit and its operation procedures in banks

Chapter III

SUMMARY AND CONCLUSION

Letters of credit make it possible to do business worldwide. The use of the letters of
credit as a tool to reduce risk has grown substantially over the past decade. Letters of
credit accomplish their purpose by substituting the credit of the bank for that of the
customer, for the purpose of facilitating trade.

Commercial letters of credit are used primarily to facilitate foreign trade. The
commercial letter of credit is the primary payment mechanism for a transaction.
The bank will issue the credit on behalf of a customer to provide assurances of his ability
to perform under the terms of a contract. Upon receipt of the letter of credit, the credit
professional should review all items carefully to insure that what is expected of the seller
is fully understood and that he can comply with all the terms and conditions. When
compliance is in question, the buyer should be requested to amend the credit.

In international trade bank acts as a third party for making hassle free business
transaction between importers and exporters. There are usually two banks involved in a
documentary credit operation. The issuing bank and the 2nd bank, the advising bank, is
usually a bank in the seller’s country. The issuing bank asks another bank to advise or
confirm the credit. Upon receipt of the letter of credit the exporter ensures shipment of
goods as per credit terms and processes all relevant documents in order to submit to the
negotiating bank for negotiation. Upon scrutinizing the documents the negotiating bank
forward the document to the issuing or reimbursing bank for getting payment. After
receiving the documents at its counter during business hour the negotiating bank have
made payment after scrutinizing the documents with strict compliance of the respective
letter of credit. Thus commercial letter of credit uses as a very important tool for settling
international commercial transactions.

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 Letter of credit and its operation procedures in banks

REFERENCES

Chowdhury, L.R. 2006. A Textbook on Foreign Exchange. Second Edn.

Paradise Printers, 44/C-1, Azimpur, Dhaka. pp. 342-345.

http://biztaxlaw.about.com/od/glossaryl/g/letterofcredit.htm

http://en.wikipedia.org/wiki/Letter_of_credit

http://www.crfonline.org/orc/cro/cro-9-1.html

http://www.creditguru.com/guestarticleLC.htm

http://www.creditguru.com/guestarticleLC.htm

https://www.key.com/pdf/sampleloc.pdf

http://www.reportbd.com/articles/84/1/Types-amp-Parties-of-LC-Letter-of
Credit/Page1.html

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