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What Is the Letter of Credit Procedure?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 11 September 2016
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Letter of credit procedure is a term used to describe the process used to apply for and obtain a letter of credit, as well as how that letter of credit (LC) is then used, especially as the means of purchasing goods produced and sold by a seller or exporter. Typically, this process will involve consideration of the resources and credit rating of the buyer by the issuing bank, working with the receiving bank of the seller, and in general making sure that the letter of credit is accepted as a guarantee of payment and can serve as the basis for allowing the transaction to proceed. Many exporters require this type of financial instrument to be prepared as part of doing business with international buyers, who are generally designated as importers.

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The initiation of a letter of credit procedure begins by the buyer making a formal application for the LC to the bank or financial institution of his or her choice. As part of the evaluation of that application, the bank will look closely at the financial circumstances of the applicant, basing the decision on factors like the total liquid assets that are in place, the credit rating of the applicant, and the degree of risk associated with approving the request and issuing the letter of credit for a specific purchase or even a collection of purchases. Once the bank determines that the applicant is creditworthy, the LC is issued and can be forwarded to the seller’s bank.

From there, the seller can work with his or her bank to comply with the terms found in the LC, such as advancing funds that can be used to manufacture and ship the order. This phase of the letter of credit procedure focuses on getting the completed order into the hands of the buyer. Upon confirmation of the receipt of the order, the issuing bank releases payment to the receiving bank, and the process is considered complete.

A viable letter of credit procedure helps to protect the interests of all parties concerned. Buyers do not actually pay for the orders until they are delivered. At the same time, sellers can make use of the letter of credit to obtain advances from the receiving bank in order to manage the costs of manufacturing the goods associated with the order and covering the shipping expenses, rather than making use of other resources to manage that part of the order fulfillment process. The actual letter of credit procedure must adhere to the trade laws that apply to the nation in which the buyer is based, as well as the country where the seller resides.

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