What Is a Confirmed Letter of Credit?
The term confirmed letter of credit refers to an additional guarantee to the original letter of credit obtained by a borrower from a second bank. This second letter guarantees that the second bank will pay the seller in a transaction if the first bank fails to do so. Borrowers may be required to get the second letter of credit if the seller has doubts about the creditworthiness of the issuing bank of the first letter. Requiring a confirmed letter of credit decreases the risk of default for the seller.
How Confirmed Letters of Credit Work
Letters of credit are negotiable instruments that are most commonly used in international trade. and in business transactions that require substantial payment for goods or services. Instead of requesting an advance payment, the seller may require the buyer to obtain a letter of credit for the balance of the payment owed at the time of full delivery. This letter acts as a guarantee from the buyer's bank that payment will be made on time and for the full amount. If the buyer fails to live up to their obligation as outlined in the contract, the bank takes on the responsibility of covering the full amount.
The same bank cannot issue the first and confirmed letters of credit.
The seller may require a second letter of credit or a confirmed letter of credit. This second letter requires the backing of more than one bank by a buyer in a domestic or international transaction. A confirmed letter may be required if the seller is not satisfied with the creditworthiness of the first letter of credit. In many cases, the second bank is the seller's bank. When the buyer gets the second letter, it confirms the first one and qualifies it as a confirmed letter of credit. The second bank promises to pay the seller the amount stated if the first bank fails to do so when it issues the confirmed letter of credit.
The process of securing the second letter of credit is the same as the first one. The buyer must find a second bank to back its purchase in case of default. The structuring of the funds for the second letter of credit generally takes the terms of the first letter of credit into consideration as well. In some cases, the seller may only require the second letter of credit represent a percentage of the total due because the sale already comes attached with a credit letter by the first bank.
Just like the first letter of credit, banks may also charge the buyer a fee when they issue a confirmed letter of credit. The amount of the fee may depend on the size of the transaction and payment amount, as well as the relationship between the buyer and the bank. In many cases, they may ask the buyer to put up securities or cash as collateral in exchange for the letter.
- A confirmed letter of credit is a guarantee a borrower gets from a second bank in addition to the first letter of credit.
- The confirmed letter decreases the risk of default for the seller.
- By issuing the confirmed letter, the second bank promises to pay the seller if the first bank fails to do so.
Buyers must work with their banks to secure a letter of credit. This requires a full credit application—the same way the buyer would if they applied for a loan. If the bank approves the letter of credit, it documents its willingness to pay the seller the stated amount if the buyer defaults at the time of payment. The terms of the letter typically structure the payment as a loan for the buyer.
If the buyer is unable to make the payment to the seller at the time when the funds are due, the bank issues the payment as a loan to the buyer. The buyer also agrees to the bank’s terms and conditions when they receive the letter. If required, the terms of the loan may include a stated interest rate and payment schedule as well as other disclosures regarding repayment.
If the seller is satisfied with the buyer's first letter of credit they may accept it as an unconfirmed letter of credit. Unconfirmed letters of credit require the support of only one lending bank which means a second or confirmed letter of credit isn't required.
Advantages of Confirmed Letters of Credit
Just like a (first) letter of credit, the confirmed or second letter of credit has advantages for both the seller and the buyer by protecting both their interests. The letter gives the seller assurance that the will receive payment after the goods and/or services are transported to the buyer. As mentioned above, if the buyer doesn't pay, the bank assumes responsibility for the payment. By getting a second letter, the risk of default drops, since another bank agrees to pay if the first one isn't able to do so. Buyers can rest assured that they will receive the requested goods and services from the seller when they obtain a confirmed letter of credit.
Example of Confirmed Letter of Credit
Here's a hypothetical example of how confirmed letters of credit work. Let's say Company A purchases supplies from Company B, which operates in a different country. In order to facilitate the transaction, Company B requires a letter of credit from the buyer's bank. Company A receives this and sends it over to the seller. Because the issuing bank of the first letter of credit is in a different country and its creditworthiness is not known, Company A tells the buyer that it needs a second letter of credit from another bank in order to complete the transaction. The buyer applies for the second letter with the seller's bank. This will likely satisfy the conditions of the sale since Company B already has a relationship with this bank.