Banks issue letters of credit when they are confident in a buyer’s legitimacy. If the buyer fails to pay, the bank must cover the amount as a partial payment or facility. Letters of credit represent significant transactions not only between financial institutions and sellers but also between international parties.
In international trade, letters of credit can provide an assurance of payment where none can be obtained through conventional background checks or legal means. Because sellers in other countries may not know the buyers personally, they may require letters of credit from the buyer’s bank to guarantee they will be paid in full, even if the buyer defaults.
How Does a Letter of Credit Work?
Letters of credit may be transferable. The beneficiary of the payment may be able to assign another party or corporate entity control of the funds. Typically, letters of credit act as negotiable instruments that can be assigned a beneficiary by the financial institution that issues them.
These banks then charge for their services and for the risk inherent in covering the buyer’s payment schedule. In international transactions, the UCP (Uniform Customs and Practice for Documentary Credits) mediates the fulfillment of letters of credit.
Letters of Credit: 4 Main Types
Different letters of credit have slightly variable relationships between the issuing banks and beneficiaries. These are the main types:
Commercial letters of credit allow the bank to pay landlords or other beneficiaries directly.
Confirmed letters of credit involve more than one bank. The confirming bank is usually the bank of the seller. These are essentially letters of credit for other letters of credit. Should the buyer and the bank default on the payments, the confirming bank will pay.
Revolving letters of credit can be drawn a predetermined number of times within a specific timeframe.
These letters of credit guarantee travelers that foreign banks honor the drafts they make. Like confirmed letters of credit, traveler’s letters involve more than one bank and are particularly useful when conducting international transactions.
Letters of Credit in Commercial Real Estate
Letters of credit can also guarantee rent payments between an issuing bank, a business owner, and the landlord. Instead of a cash security deposit on a commercial property, a bank may issue a letter of credit to the landlord. This transaction guarantees them the payments on their commercial real estate, even if the business defaults on them.
Some businesses prefer to devote their cash to their business rather than front the security deposit. The bank may require collateral, such as the business owner’s home mortgage, to accept the letter of credit. Once approved, you can skip the security deposit in exchange for the landlord’s withdrawal rights in the event that you cannot pay your lease.
Note that landlords cannot withdraw without provocation. The bank will not permit withdrawals unless the business defaults on its lease. Often, landlords are required to present proof of defaulted payments when requesting their money.