A letter of credit is mostly utilized in international trade or import/export transactions. In this article, we will mention the procedures & costs of a letter of credit and differences in Germany, Poland, the Czech Republic, Hungary, Turkey, and Estonia.
What Is The Definition of “A Letter Of Credit”?
Letters of credit impose constraints, privileges, and disadvantages on traders and sellers. Since the nature of letters of credit can be somewhat complex, we’ve compiled a list of the most crucial facts you should know about them in this article.
A letter of credit is a contract between a bank and a client in which the bank agrees to pay the beneficiary upon delivery of specific papers. The parties involved in letters of credit are the issuing bank (which opens the letter of credit), its customer (who orders the letter of credit), as well as the payee and its bank. In foreign trade, for example, the importer (or payer) opens the letter of credit with his bank. The format of the documentary letter of credit is frequently selected. The importer requests documentation from the exporter as verification that the delivery fits the agreed-upon specifications. If the exporter submits these documents to his bank and they match the terms of the letter of credit, the importer’s bank pays the exporter.
Benefits of a Letter of Credit
Both the importer and the exporter benefit from the above definition. Both parties may be confident that the trade is secure, even across national borders, thanks to the involvement of banks. The exporter has a high level of assurance that he will be compensated for the delivery. Furthermore, the letter of credit permits the money to be collected from the bank rather than the importer directly. The importer, on the other hand, has the certainty that payment will not be issued to the exporter until all the terms of the letter of credit are met. A letter of credit is thus a guarantee to pay made by the importer’s bank, not the importer. This greatly increases the security for the exporter that he will get his money.
Procedure For a Letter of Credit
A purchase agreement must be signed between the importer and the exporter before a letter of credit is obtained with the bank. When it comes to payment, both parties are at odds: the exporter prefers payment in advance, as this ensures that he will not incur any financial loss due to non-payment after delivery of the goods; the importer, on the other hand, prefers payment on account, as this ensures that the goods also meet the requirements before he pays. The solution to this dilemma is now the letter of credit.
The importer opens a documentary letter of credit with his bank, which specifies which documents the exporter must present to receive payment. In most cases, these are the invoice, a delivery bill with a description of the goods, and proof of shipment. The exporter ships the goods and submits the necessary paperwork to his bank. They are then checked and sent to the importer’s bank. If the documents match the requirements of the letter of credit, the opening bank begins payment.
The Cost of a Letter of Credit
Because the bank works as an intermediary between the importer and the exporter, and an additional expense is incurred due to document verification, as well as a risk due to non-payment, the bank naturally permits itself to be compensated for this through letter of credit fees and commissions. Because there is more security for both, the importer and exporter frequently split these costs. Most banks charge tiers of fees that decrease as the overall worth of the goods increases. Because there is typically a minimum rate, letters of credit are only genuinely useful for higher-value commodities. Here you should compare offers from different banks in advance and discuss cost-sharing with the exporter.
Different Types of Letters of Credit
• Unconfirmed letter of credit
An unconfirmed letter of credit provides only a bare minimum of protection to the exporter, as it merely symbolizes the foreign bank’s pledge to pay. However, there is no guarantee that the payment will be made since, for example, the bank may be in financial difficulties and unable to pay, or a payment moratorium may be imposed in the nation where the bank is based.
• Confirmed letter of credit
A confirmed letter of credit can be arranged to boost payment security for the exporter. Even if the importer’s bank is unable to forward the payment to the exporter’s bank, the exporter’s bank accepts the risk of non-payment and pays the exporter the amount due. As a result, the domestic bank mitigates the foreign risk.
• Deferred payment letter of credit
This sort of letter of credit is most referred to as a documentary letter of credit, as detailed in detail above. A payment period is the only distinguishing aspect of a deferred payment letter of credit. This means that the payment is not forwarded to the exporter’s bank until a pre-agreed-upon amount of time has passed. As a result, in theory, this is a supplier credit.
The Importance of Letter of Credit for Companies
Letters of Credit are typically legally binding; thus, all parties must agree to revoke them, which is also why it is safe. Since the items stated in an LC are particular and well defined, the specifics of a transaction are often quite transparent, and this is a reason for clarity. The companies can’t work with risk, so the payment to the exporter or seller is assured if the provisions of the LC are met which is reducing the risk. Allows safe trading, letters of credit are a focus of international trade and allow companies to trade safely in unfamiliar markets with unfamiliar suppliers. Letters of Credit can be raised electronically utilizing an online trade banking service, which saves time.
• International StandbyPractices ISP98: Thesearetherulespreparedby ICC specificallyforstandbyletter of credit.
• UCP 600: Rules prepared for commercial letters of credit.
Letter of Credit in Germany
Most import transactions by German customers, especially those involving large German distributors, take place under seller-buyer terms, such as the common 30/60/90-day accounts, or payment against documents. The letter of credit is still used in some industry sectors but now covers a fraction of total imports, largely due to its cost and time requirements as well as the ease in obtaining credit ratings in Germany, which increases transparency and transactional safety. L/C’s for payments under USD 5,000 are almost unknown in Germany.
Germany’s universal banking system permits the country’s more than 1,679 banks and savings banks, as well as its network of 25,800 branches, to accept deposits, provide loans, and trade in securities. There is no evidence of a credit crunch in the German economy. Credit is offered to both domestic and foreign investors at market-determined rates, and a variety of credit products are available. In the past, the traditional German system of cross-shareholding between banks and industry, as well as a high rate of bank borrowing relative to equity financing, allowed German banks to wield significant influence over the industry.
Private banks control around 40% of the market, while publicly owned savings banks largely tied to state and local governments account for 50% of banking transactions, and cooperative banks account for the remainder. All three types of banks provide a comprehensive range of services to their consumers. KfW, a state-owned bank, offers specialized credit services such as mortgage financing, guarantees to small and medium-sized firms, funding for projects in disadvantaged areas of Germany, and export finance for projects in developing countries.
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Letter of Credit in Poland
Import finance operations in Poland are conducted on a seller-buyer basis. Payment against documents and electronic cash transfers are two popular payment methods. An irrevocable letter of credit (L/C) is the safest way to receive money for a US export sale. However, because most banks in Poland require the importer to deposit funds before issuing an L/C, few buyers and sellers employ this technique because of the high cost. Electronic funds transfer (SWIFT or wire transfers) is the most used payment mechanism because it is the quickest and cheapest means to move payments. Cash payments or down payments add a layer of security to export sales. Leasing is a popular way to finance vehicles, heavy machinery, and other capital-intensive things. Both private and public insurance is available in Poland.
The popularity of online and mobile banking continues to grow, causing bank networks and employment to shrink. Polish banks are leaders in their use of technology. According to a Deloitte survey, in 2020, Polish banks ranked fourth in the world in terms of using digital technologies. The COVID-19 pandemic and related restrictions had a significant impact on the development of digital bank channels.
In Poland, insurance is accessible. Banks are beginning to monetize the electronic tools they supply to their customers. All of Poland’s main banks provide online services ranging from balance-cheque operations to cash transfers and deposits. Deposits and loans are accessible in the local currency, the Polish zloty (PLN), as well as in other currencies. The Financial Supervision Commission (KNF) has limited the availability of loans in euros and Swiss francs to reduce the banking system’s exposure to currency risk caused by fluctuating exchange rates. Individuals who receive incomes in foreign currencies (e.g., Euros, Swiss francs, US dollars) continue to have simple access to foreign currency loans. Tight controls on foreign currency lending aim to limit banks’ and borrowers’ exposure to a severe drop in the PLN’s value. Borrowers are required under credit agreements to give information about their economic and financial situation.
Letter of Credit in The Czech Republic
Most Czech firms use prepayment or partial prepayment, with the balance due upon delivery or net 30-day terms. For shipments under $2,000, consider asking the buyer to pay by credit card. Czech firms are familiar with letters of credit, documentary collections, and wire transfer/cash in advance. Most would prefer not to use a letter of credit due to the high cost. Many small Czech businesses cannot afford or secure financing.
Moody’s Investors Service EMEA Limited Czech Branch is the only credit rating agency in the Czech Republic. There are 25 major collection agencies, 80 percent of which are members of the Collection Agencies Association – in Czech only). The Association is a member of FENCA (European Federation).
The main credit cards used in the Czech Republic are MasterCard and Visa which are issued by all major local banks. The most common type is debit cards (about 70 percent of all cards) followed by credit cards (about 28 percent). Charge cards issued by Diners Club and American Express are rarely used by Czechs although they are generally accepted in tourist area shops, large hotels, and shopping malls. American Express Personal Cards are available in the Czech Republic. They are denominated in U.S. dollars or euros, issued in the UK, and serviced in English.
Three banks dominate the banking sector: Ceskasporitelna, CSOB, and Komercni banks, all of which are owned by foreign bank financial conglomerates. The Czech banking sector is comparable to the banking sectors of other comparable-sized Western European economies. Investment banking, investment funds and advising, brokerage, underwriting, insurance, pension funds, and leasing are only a few of the products and services offered by foreign and major domestic banks. The Czech National Bank oversees banking supervision.
Letter of Credit in Hungary
The National Bank of Hungary (Magyar Nemzeti Bank – MNB) is the central bank and a member of the European System of Central Banks (ESCB).
The MNB and the members of its decision-making bodies perform their duties and carry out their obligations independently from the government. Except for the European Central Bank, the MNB (and the members of its decision-making bodies) may not ask for or follow instructions from the government, the institutions and bodies of the European Union, the governments of other EU member states, or any other institution or body.
Since their inception in 1993, the Hungarian Development Bank – a bank that provides favorable credit facilities to Hungarian businesses implementing economic development projects – and Eximbank – a bank that serves Hungarian exporters by providing effective financing and insurance – have been owned by the state. MKB and Budapest Bank became state-owned in 2015, bringing state ownership to more than 50% of Hungary’s banking sector. Although foreign investors had formerly controlled 80 percent of Hungary’s banking sector, this figure had fallen to 47 percent in 2016. Foreign ownership has been critical in transforming the previously one-level banking sector into a double-level one that matches international standards.
A bank account at a commercial bank is required to register and run a company in Hungary. Wire transfers are used for more than 80% of payment transactions, and new customers are sometimes required to pay in advance. A letter of credit is often used for more significant and high-value first transactions before mutual trust develops between partners. Credit cards are also used but mostly for individual purchases. The largest commercial banks in Hungary are OTP – Hungarian Savings Bank, MKB, Commercial and Credit Bank (K&H), UniCredit, Erste, Raiffeisen, Budapest Bank, and CIB Bank. They are all members of the Hungarian Banking Association.
There are no foreign exchange controls in Hungary.
Letter of Credit in Turkey
ATR certificate is required for exports to European Union member countries. By the Free Trade Agreement between EFTA countries and Turkey, EUROl Certificate is required for exports to these countries.
The banking sector plays less of a financial intermediary role than one would expect in an economy of Turkey’s size and sophistication. The three state-owned commercial banks plus Turkey’s nine largest private banks account for 90% of total bank assets. Turkish banks engage in core banking services, securities brokering, and other businesses.
The Borsa Istanbul is the sole exchange entity of Turkey combining the former Istanbul Stock Exchange (ISE), the Istanbul Gold Exchange, and the Derivatives Exchange of Turkey under one umbrella. The Capital Markets Board of Turkey, based in Ankara, is responsible for overseeing the activities of capital markets. The Banking Regulation and Supervision Agency (BDDK) and the Central Bank of the Republic of Turkey are responsible for the integrity of the banking system.
Letters of Credit (LCs) are traditional import instruments for private-sector transactions. As Turkish importers develop long-term contacts and prove their creditworthiness, suppliers may be willing to accept documents against payment (d/p) or documents against acceptance (d/a). Deferred payment schedules are not common, except in cases of large transactions where supplier financing plays a role.
Letter of Credit in Estonia
Cash or non-cash payment options can be used to purchase goods and services. The Estonian payments sector has come a long way over the years, and electronic methods of payment are now the norm. More than 99 percent of bank payments are begun electronically, with only 1 percent using non-electronic methods such as cash payments, paper-based payment orders, or cheques.
The Bank of Estonia, known as “EestiPank,” is the independent central bank. As Estonia is part of the Eurozone, the core tasks of the Bank are to help to define the monetary policy of the European Community and to implement the monetary policy of the European Central Bank. EestiPank is also responsible for holding and managing Estonian official foreign exchange reserves, supervising overall financial stability, maintaining reliable and well-functioning payment systems, and the circulation of cash in Estonia.
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All rights reserved. All rights of the Letter of credit article belong to Gurcan Partners. The author has no responsibility for the information in this article. This article is prepared just to inform.
Simge Ayse Pala LLBs
Gurcan Partners Europe