What is a Bank Letter Of Credit Policy

A bank letter of credit policy is an insurance policy held by U.S. banks to ensure the authenticity of letters of credit issued by foreign financial institutions.

BREAKING DOWN Bank Letter Of Credit Policy

A bank letter of credit policy reduces the risk a bank takes when it engages in foreign transactions. A letter of credit is a payment mechanism used in international trade to guarantee payment of a specific amount at a specific time. Issuing banks fund letters of credit based upon collateral pledged by the party on whose behalf the bank will guarantee payment. International trade relies heavily on letters of credit to reduce friction when parties do not have an existing financial relationship, and therefore cannot accurately gauge the reliability of contracting parties. In effect, the issuing bank underwrites the buyer's credit risk and acts as a trusted counterparty.

A bank letter of credit policy provides sellers with insurance coverage should the issuer become unable to guarantee payment, for example in the event of political strife or large movements in foreign exchange markets. Policies typically cover any situation that affects the convertibility of a letter of credit, though they may restrict elements of the transaction such as the type of letter of credit involved or the source or destination of the goods for which the letter of credit provides payment.

Policies Issued by the Export-Import Bank

The Export-Import Bank of the United States issues policies to cover irrevocable letters of credit involving the export of goods produced in and shipped from the United States. These policies require that the covered bank have an existing relationship with the foreign bank that issues the letter of credit. Irrevocable letters of credit further reduce nonpayment risk since they cannot be modified without the explicit consent of the seller, buyer and issuer. Coverage options include comprehensive coverage of both commercial and political risks to the convertibility of the letter of credit or coverage of political risk only. The latter coverage extends to disruptions such as war or regional disasters causing financial disruption at issuing banks. Coverage limits range from 95 to 100 percent of the letter of credit's principal amount, depending on the issuer, as well as a specified interest rate based upon a discount from the prime rate. The bank prices its premiums according to the risk involved in a given transaction.

These policies do not offer coverage for situations in which the issuer and the insured party have an existing, unresolved dispute regarding documentation of a previous letter of credit.