Letter of Credit

A letter of credit (LC) is an instrument in which a bank commits to pay the seller when presented with documents that conform exactly to the LC's terms, typically shipping documents proving the goods were dispatched as agreed. The seller stops relying on the buyer's willingness and ability to pay and relies instead on the issuing bank. LCs dominate international trade with unfamiliar counterparties and appear domestically on very large transactions or high-risk accounts.

The two forms matter to credit managers in different ways. A commercial (documentary) LC is the payment mechanism itself: present conforming documents, get paid. A standby LC sits behind an open-account relationship as a guarantee, drawn only if the buyer fails to pay; it is a common way to grant terms to a customer that would otherwise fail underwriting, since the customer's bank has effectively underwritten them for you. Standby LCs supporting open lines should have expiry dates tracked like any other collateral, with a rule to reduce the line before the LC lapses.

LCs pay on documents, not on goods or intentions. Banks apply strict compliance: a misspelled name, a late presentation, or a document mismatch can justify refusal even though the goods shipped perfectly. Sellers using LCs need document discipline (and often a freight forwarder or bank that reviews presentations), and should price in bank fees and the buyer-side cost, because an LC consumes the buyer's bank facility, which is why buyers resist them.