Letters of credit are issued by the bank to his customers specially the businessman to provide facilities in the business transaction in different places. There can be personal letters of credit and commercial letters of credit. Commercial letter of credit is used in foreign trade when one exporter wants to get the value of his exported goods before the delivery of importers, and the importers in such a situation get help from bank in the shape of issuing “Letter of Credit”, to receive the delivery of the good.
Letters of credit state the limit of the credit and the time during which it is held at the disposals of the guarantee, but these are not negotiable or transferable. It helps the exporter and importer as well as it is source of revenue for a bank in the form of commission. It promotes foreign trade and facilities foreign payments.
How to Open Letters of Credit
The following steps are involved for opening of Letters of credit
- Sales Contract
The importer contacts the exporter for purchase of goods. He settles with the seller about the prices, quantity of goods and mode of making the payments. Then importer files an application to open a letter of credit.
- Performa Invoice and Import license
The banker will ask the applicant to provide import license and Performa invoice or indent of goods to be imported. After checking these documents, the banker will ask the importer to file an application on the printed form.
- Application Form
A printed application form usually known as Application and agreement for irrevocable letter of credit is fitted up by the banker and signed by the importer. All terms and conditions of sale contract are recorded in it.
- Completion of Form
The letters of credit forms are filled in by the banker as per information of application. All terms and conditions are also stated in this form.
- Information to Advising Bank
The issuing bank informs the advising bank that credit has been issued. Three copies are prepared. One copy is kept by the issuing bank and other two copies are sent to the advising bank, one copy to the exporter.
- Margin Requirements
The State bank decided the percentage of amount to be paid to the issuing bank by the importer. This amount is called margin.
- Information to the Seller
The advising bank informs the seller that credit has been issued. The seller sends the goods to the buyer and provides the shipping documents to the advising banker. The bank checks the documents and then sends to the issuing bank.
- Payment to the Seller
The issuing bank on the receipt of shipping documents, effects payment to the seller. The shipping documents are released to the buyer upon payment of the amount due. Thus the process opening letters of credit got completed and business transactions took place.
Kinds of Credit Instruments
As we know that Cheque, Bill of Exchange and Promissory Note are various types of credit instruments. There are also some other banks and credit instruments, which are as under:-
- Bank Draft
- Bank Note
- Postal Order
- Traveler’s Cheque
- Bank Draft
It is written order from one branch of a bank to another branch to pay certain sum of money to the holder of the bank draft. How the bank draft is issued? Any person whether the client or not can get a draft filling the draft from issued by the bank containing the column relating amount, venue, place and other information necessary. This form duly completed and signed is handed over to bank along with the amount and commission. Bank then issues the bank draft as desired. In case, the draft is lost and bank is informed well before the time and making any payment, a duplicate bank draft can be issued by the bank on the request of the customer after the cancellation of previous one.
Parties to Draft
There are three parties to a bank draft:-
Drawer is the branch of the bank who issues the draft.
Drawee is that branch of the bank to which the order is issued for payment of the draft.
The person who receives the payment of the bank draft is known as the payee.
These credit instruments is the most simple and easiest way for the transfer of money from one place to another without any risk. Large amounts of money are transacted in different business and industrial units. Bank Draft has made the payment and receipt easy. It is also the most secure mode of payment, because the draft is issued after the full value already received. Bank has full responsibility for the payment of drafts.
- Bank Note
The next type of credit instruments is Bank note and defined as “Note which is issued by a bank directs anybody to pay on demand and later on may be re-issued after payment, they are practically money and in the ordinary course of business are treated as cash”.
- Postal Order
The next type of credit instruments is Postal Order. It is issued by post offices and used for the purpose of transfer of money from one place to another. It has two parts, the postal order and the counterfoil. These are non-negotiable instruments, hence cannot be transferred to any other person for the receipt of the cash, even if these are lost.
- Travelers Cheque
These cheques are issued by the commercial banks for the expediency of traveler relating their requirements of cash during travel. Earlier than issuance of bank draft, the banker receives total value of the cheque and also the commission. Traveler’s cheque is for permanent amount to be paid to purchaser only whose specimen signatures appear on cheques. These credit instruments or travelers cheques are used for travelling abroad as well as in home.
Hello everyone! This is Richard Daniels, a full-time passionate researcher & blogger. He holds a Ph.D. degree in Economics. He loves to write about economics, e-commerce, and business-related topics for students to assist them in their studies. That's the sole purpose of Business Study Notes.
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