Introduction to Documentary Credits

Introduction: Banks, as we know, lend money to the public, for various purposes. Like purchase of a home, a car, or other consumer durables etc. They also extend loans to Industries that manufacture various goods, and machineries, and also to service industries that provide various services, like a salon, internet kiosk, etc., to the community.

Banks play a vital role in the development process of any nation, by providing finance for different activities related to trade and commerce. This includes both domestic and international trade and commerce.

One of the ways in which commercial banks facilitate international trade and commerce, is by way of extending a non funded financing facility or mechanism called the Documentary Credit (DC), or the Letter of Credit (LC).

This mechanism to facilitate international trade was developed under the auspices of the International Chamber of Commerce, Paris. The rules and regulations etc., governing the Documentary Credits, and the transactions thereunder, are contained in what is known as the Uniform Customs and Practices for Documentary Credits.

Definition: A Documentary Credit (DC), or Letter of Credit (LC), (they are one and the same), is a legally binding undertaking given by a Bank on behalf of its customer, in favor of a third party, to make payment to him (the third party), the stated sum of money against submission of the required documents, as per the terms of the DC.

A simple example of a DC transaction goes thus: English Oriental Bank, a commercial Bank, based in London, U.K., establishes a DC on account of one of its clients, M/s. Hudson Industries, favoring a Software Company in Bombay, India, by name, Zed Software Co. Details of this Documentary Credit and how it works is discussed below.

The underlying contract of this DC is as follows: Zed Software Co (ZSC) has a contract to supply to Hudson Industries, technical software, related to the maintenance of a gas turbine, under contract, by Hudson Industries. The value of the contract is Pound Sterling 500,000.00. The typical problems and issues that can arise from a business proposition like this, may relate to the different rules and regulations of trade, in the respective countries; the different currencies, and the differing exchange rates applicable to them; the different customs and practices prevailing in the two countries, that can pose communication and other problems between the buyer and seller etc. That apart, the buyer and seller, in this case, the Hudson Industries, and Zed Software may not know each other, and may not be sure as to how far they can trust each other.

Each of them may confront questions for which they have no answers. Like, Zed S0ftware may find more comfort in receiving advance payment from Hudson Industries, before supplying them the software. On the other hand, Hudson Industries is not sure of receiving the contracted for software, if it makes advance payment. Or the software may not be of the same quality etc that they had sought and paid for. So they would like to receive the software in advance, so they could check the same and satisfy themselves. Hence, there would be a stalemate here, with neither of the parties budging from their respective positions.

It is here that Banks come into the picture, along with their tools to facilitate transactions like these, between buyer and seller, based in different countries. Now, in a case such as this, Hudson Industries would approach their Bankers, the EOB, to open a DC in favor of their Indian supplier, Zed Software, for the supply of the software, in the value of Pound Sterling 500,000.00.

Let us assume that EOB accede to the request of their customer, and establish a DC for the amount of Pound Sterling 500,000.00, favoring Zed Software Co, subject to terms and conditions as per their credit policies. EOB then advises this DC to Zed Software, through their Correspondents in India, say, Indian Future Bank (IFB), who, in turn, would advise the DC to Zed Software. Let us assume that Zed Software is a client of IFB. Upon receipt of the DC, the company would know they kind of product or service it is expected to supply to Hudson Industries, and other details relevant to the contract.

According to the terms of the DC, ZSC is required to submit documents as per DC terms, in relation to the contract for the supply of the software to Hudson Industries, and claim payment from their own Bank, the IFB. Some of the most important documents to be submitted under this transaction include the commercial invoice, the bill of exchange, the certificate of origin, the transport document like the airway bill, etc. The IFB, upon receipt of the documents, from ZSC, scrutinize the same, and if they are in consonance with the terms of the DC, make necessary payment to their customer, and in turn, claim reimbursement from EOB, the Bank that established the DC. EOB, in turn, scrutinize the documents submitted by the IFB, and if found in order, reimburse IFB for the amount claimed by them. Thereupon, the EOB present the documents to their customer, Hudson Industries, and recover the money paid by them to the IFB.

This is a simple example of how a DC works. This example pertains to one particular type of DC, of which there are many. It is also assumed in this case, that there are no complications throughout the transaction, and it ends peacefully, with all the parties concerned happy about the outcome.

In real life situations, of course, many a problem arises, either in respect of the documents submitted by the beneficiary, or the manner in which the two Banks, or the parties handle the transaction, or any other reason related to the transaction.

Conclusion: Banks, as facilitators of international trade and commerce have been served well by the mechanism of the Documentary Credit. The beauty of these credits is that they provide appropriate protection, as required, by the seller, buyer, the seller’s Bank, and the buyer’s Bank, while extracting their share of responsibility under the transaction.

The DCs have acted as a sort of bridge between buyers and sellers of goods and services, based in different countries, bringing them together, through the agency of the Banks.

Since they came into being in 1933, DCs have no doubt played a significant role in cross border trade, overcoming the barriers of language, customs and practices, currencies, etc. And last, but not the least, they are an important source of business and revenues to the Commercial Banks, and are expected to grow even more in importance, in the coming years.

This entry was posted in Finance. Bookmark the permalink.