Bank Letter of Credit Policy

Bank Letter of Credit Policy

Investopedia / Jiaqi Zhou

Bank Letter of Credit Policy: An Overview

A bank letter of credit policy is a guarantee by a U.S. bank that a buyer in a foreign transaction will be paid. This type of credit letter has become a routine part of international transactions, which often involve shipping large quantities of goods with a promise of payment from a foreign bank when the goods are delivered.

In establishing a letter of credit policy, a bank undertakes responsibility for paying a seller in the event that a buyer fails to make good on a payment. The policy serves as insurance for the seller in the transaction.

Understanding the Bank Letter of Credit Policy

A bank letter of credit policy reduces the risk that a bank and its customer take when engaging in foreign trade.

A letter of credit is a payment mechanism used in international trade to guarantee payment of a specific amount in a timely manner. Issuing banks undertake letters of credit based on collateral pledged by the party on whose behalf the bank is guaranteeing payment.

International trade relies heavily on letters of credit to smooth transactions, particularly between parties that do not have an existing business relationship. In effect, the issuing bank underwrites the buyer's credit risk and acts as a trusted counterparty.

The bank may also issue a letter of credit to guarantee the seller's financial solvency.

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 source or destination of the goods for which the letter of credit provides payment.

Key Takeaways

  • A bank letter of credit policy guarantees payment in a foreign transaction.
  • Coverage options span a broad range of commercial and political risks from war or natural disaster to a financial calamity at the issuing bank.
  • The Export-Import Bank of the United States issues policies to cover irrevocable letters of credit.

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 the U.S. and shipped from it. 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.

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 extends to disruptions such as war and regional disasters that cause financial disruption.

Coverage limits are typically 95% to 100% of the letter of credit's principal amount and a specified interest 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.

Example of Letter of Credit

Let's say that Company ABC is a manufacturer located in China. It recently entered into an agreement to supply widgets to Company XYZ in the U.S.

All goes well until political tensions arise between China and one of its neighbors. ABC's factory at the border may be in danger of a prolonged shutdown. Such a disruption could adversely affect XYZ's operations and upend its plan to manufacture the number of widgets it intended to deliver.

A letter of credit policy could help insure XYZ against such an eventuality by providing monetary compensation for losses suffered due to the unexpected crisis.

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  1. Export-Import Bank of the United States. "LETTER OF CREDIT: INSURANCE FOR BANKS." Accessed Dec. 29, 2020.