Advising banks and negotiating banks are responsible for a type of financing that is referred to as a “letter of credit.”
A letter of credit is an approved international payment method. It is a letter which guarantees a buyer’s payment to a seller, which includes a specific amount and time frame for the payment to arrive.
If the buyer would be unable to make a payment on the purchase being made, then the banks responsible for the letter of credit would then be required to make the payment.
Because there can be delays in the issuance of payment when companies or individuals initiate transactions in 2+ countries, the letter of credit has become a useful tool. If the bank guarantees the payment, then makes it for the company or individual, then they can be paid back for what they issued.
Some letters of credit are transferable.
What Is an Advising Bank?
An advising bank is responsible for notifying an exporter that they have received an approval for the opening of a letter of credit. The advising bank is usually located in the country of the exporter. It will inform the exporter of what the conditions for the credit will be without making a commitment for payment.
What Is a Negotiating Bank?
When conducting a letter of credit transaction, the negotiating bank fulfills three specific roles.
#1. It receives, then examines, the documents of the seller to ensure that they adhere to the terms and conditions that are required for the letter of credit.
#2. It provides value to the seller, assuming that the terms of the credit line have been met.
#3. It then forwards the letter of credit to the issuing bank, which could be an importer bank or some other buyer’s bank.
The negotiating bank may either pay the seller of the exporter immediately under the terms and conditions of the letter of credit or pay once it has received funds from the issuing bank to do so.
How Is a Letter of Credit Funded?
A letter of credit is funded when a bank pledges cash, collateral, or securities when the letter is issued. The bank will also collect a service fee for this guarantee as part of the transaction, which is usually a specific flat percentage of the amount involved in the letter of credit.
No matter who the advising bank or negotiating bank happens to be, the International Chamber of Commerce Uniform Customers and Practice for Documentary Credits is responsible for overseeing this financial tool when it is used for an international transaction.
Different Types of Letters of Credit
The most common type of letter of credit that is issued is referred to as a “confirmed letter of credit.” This involves a bank other than the issuing bank providing the guarantee for the letter of credit. It will usually be the seller’s bank, but it could be any bank willing to guarantee the letter of credit in exchange for the fees involved.
Advising banks usually request this type of arrangement when an international transaction is desired.
Another option is called a “revolving letter of credit.” With this option, a buyer can choose to make withdrawals from their letter of credit, within a specified limit, over a specific time period. The letter of credit would guarantee that the issuing bank would honor the draft requests over the time it is active.
The third option is called a “commercial letter of credit.” It is a direct payment method that is used with this type of transaction. The issuing bank in this transaction would make the payment to the beneficiary immediately.
Another option that is available to advising banks and negotiating banks is called a “standby letter of credit.” Although it is somewhat uncommon, this option provides a secondary payment method where the bank will pay the beneficiary in the transaction only when the holder of the letter of credit cannot do so for some reason.
When a Letter of Credit is Needed
A letter of credit is needed whenever a buyer or seller, the importer and exporter respectively, decided that they want to do some business together. After a price is agreed upon, along with the other terms of the contract, the specifics of how goods will be shipped to the buyer are negotiated.
At this stage of the agreement, a letter of credit is required. The exporter needs confidence that they’ll receive funding for the purchase, provided by the importer. This is often done when a first purchase between the two parties occurs, the purchase is large enough to cause financial hardship if not paid, or something goes wrong with the shipping portion of the transaction.
Although the letter of credit is part of the sales agreement between an exporter and importer, it is a separate document issued by the bank(s) involved.
A letter of credit is a legally binding document. It is a document which is interpreted literally, so every term with the agreement must be included to ensure that the payments will be issued as promised.
Example of a Letter of Credit
Citibank is a frequent participant in transactions which include a letter of credit. They offer letters of credit in Africa, Asia, Latin America, and some regions of Europe when companies or certain individuals may be unable to obtain international credit on their own to make their required purchases.
When Citibank issues a letter of credit, it allows exporters to minimize their risks when dealing with an importer’s nation. This also reduces the commercial credit risk of the issuing bank.
Most letters of credit that are issued by Citibank come 2 business days after the application is receive d from the client. Payment is then guaranteed by the Citibank branch which confirmed the letter of credit.
This action allows for stability when economic situations may be unstable for any reason.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.