When expanding the business, many companies find new partners and conclude agreements with them. At the same time, there is a risk of failure: non-payment of funds is possible, ignoring the terms of the contract, refusal to supply goods, etc. In order to protect themselves and guarantee the success of the transaction, they resort to settlements with letters of credit at the bank. This method of making payments fully ensures compliance with all agreements between partners and satisfies the requirements and expectations of the transaction of both parties.
The essence of the payment order
A letter of credit is a financial obligation of a bank to pay by bank transfer the documents of the seller’s client in the amount and on the terms specified in the document. All details are determined by the buyer, about which he informs his bank, having also submitted a completed application for opening this credit account. Settlement under a letter of credit is a good way to secure the transaction for partners under the terms of the contract.
There are cash and documentary payment orders. The first type is registered documents providing for the payment of a certain amount by an individual or legal entity for its withdrawal in another country. The second type is, in fact, an agreement on the basis of which the client's bank must, in accordance with its instructions, pay money to a third party. This commercial organization may instruct another bank - the fourth party - to make a payment after providing the agreed documents.
Transaction participants
In the design and implementation of calculations of this type take part:
- Buyer - an individual or legal entity (bailor, importer), he initiates a bank payment by letter of credit under an agreement in favor of the seller and transfers the necessary amount of money to the bank account;
- issuing bank: it opens a letter of credit and assumes obligations to the seller on behalf of the buyer;
- a bank that pays a letter of credit (performing bank);
- seller (exporter, beneficiary) - a person in whose favor a letter of credit is opened and to which funds will be credited.
The issuing bank can be both the executing bank at the same time, that is, it opens a letter of credit and pays the recipient the funds when the latter submits the documents stipulated by the payment order. But often the authority to pay is transferred to the executive bank. This occurs mainly when the buyer and seller are in different countries. In this case, it is inconvenient to make settlements with checks. Settlements by letters of credit are the best way to build trust. Therefore, the issuing bank does not work with the clerk directly, but by attracting the fourth party - the executive bank, which is located in the country of the recipient of funds. This bank informs the seller about the letter of credit and its conditions, and confirms the authenticity of this payment obligation.
Important detail
When paying for the goods in the aforementioned way, banks work only with documents provided by the applicant. These organizations have no relation to the product. Existing agreements between the buyer and seller are also not taken into account. Non-cash payments by letters of credit provide only the documentary party agreed upon at the opening of the payment obligation. And people who want to use this type of payment should consider this point.
The need for a bank guarantee
The provision of a loan to the client by the executive bank in accordance with the agreement is quite common. Settlements through a letter of credit are often executed when conducting foreign trade transactions, or when expanding the sales market. It happens that the supplier does not want to provide the goods without a guarantee of payment, and the buyer refuses to pay, not being sure that the agreed products will be delivered in accordance with the terms of the contract. In this case, settlements on a letter of credit is a way to reach consensus between the parties to the agreement.
Non-cash payment procedure
Money transfer in the form of a letter of credit is carried out in several stages:
- Signing an agreement between the seller of the goods and the buyer.
- The latter submits an application to the issuing bank for the opening of a letter of credit. An official notification (by telegraph or mail) of the counterparty bank (contractor) about the opening of a letter of credit to the seller.
- Delivery to the buyer of goods.
- Submission of documents: from the seller to the executive bank, from the latter to the issuing bank, from him to the buyer. Write-off of funds from the buyer's account.
- Transfer of funds to the executive bank from the issuer. Making payment to the seller.
During the transaction, the issuer deducts the amount agreed in the contract from the client’s account and sends it to the executive bank, which by analogy selects the “Letter of credit” payment form and pre-deposits the funds intended to pay for the goods (“deposited letter of credit”). But there is also a "guaranteed letter of credit." Then the payment is made only under the guarantee of the bank.
In case of a letter of credit deposited, the issuing bank transfers to the counterparty bank the amount agreed upon in the contract for the full duration of the payment obligation. Funds are provided by the buyer, or a loan is issued to him, within the framework of which payments are made.
In the case of a guaranteed letter of credit, the executive bank is entitled to debit the funds from the correspondent account of the issuing bank within the amount of the letter of credit, or provides for other payment methods. The procedure for compensation of cash to the issuing bank by the payer is prescribed in the contract.
When the goods are shipped and the supplier confirms this fact with relevant documents, the executing bank pays for the transaction. Thus, the time available for calculations is significantly reduced.
Types of letters of credit
Bank payment orders are divided into the following:
- Irrevocable: the payer cannot change the terms of the obligation unilaterally, without prior agreement with the payee.
- Revocable: the payer has the right to change the terms of the contract without agreement with the recipient of funds and may withdraw it before the end of the agreed period.
- Confirmed - the executing bank assumes responsibility for the payment.
- Unconfirmed - the bank does not undertake to control the payment.
- Renewable (revolving) - letter of credit, which is repeated when the transaction is repeated or they are systematic.
- Cashless payment with a red reservation is the provision of authority to the executive bank to make an advance payment to the seller for a certain amount before providing the necessary documents.
- Transferable - used if other persons are suppliers of goods. Then the procedure for calculating letters of credit changes a little: the seller instructs the executing bank to partially or fully transfer to them the authority to receive funds.
- Cumulative - provides an opportunity for the applicant to add the amount that was not spent during the transaction to the new letter of credit held in the same executing bank (in another case, the finances are returned to the buyer's account with the issuing bank).
- Circular: makes it possible to receive money at any banks - counterparties of the issuing bank that provided the loan.
Settlements under a letter of credit are always non-cash transactions involving only one individual or legal entity to be paid for.
Subtleties of the operation
When making payment obligations of this type, customers must take into account some nuances:
- In case of a change in the terms of the revocable letter of credit or its cancellation, the issuing bank must inform the recipient of the funds about this fact. This must be done no later than the business day following the day when the changes were made.
- An irrevocable letter of credit is considered to be amended or canceled when the executing bank receives consent from the recipient of the funds. A partial change in the terms of the letters of credit by the latter is not allowed.
- In order to amend or cancel a confirmed letter of credit, the consent of the executing bank and the recipient of funds is required.
- Settlements under a letter of credit are payments made by commercial organizations, therefore, the recipient of the funds learns about the opening of a monetary obligation directly from the issuing bank or from his bank (with the consent of the latter).
- This type of payments are made only by bank transfer.
- The payment of funds under a letter of credit is regulated by customer agreements with banks and agreements between the latter.
Application form
To pay for the goods in the above way, the payer submits to the bank 2 applications, which are an instruction to the bank to open a letter of credit. The application is submitted in the form developed by the company itself. The following data should be indicated:
- date and number of the document;
- amount of payment;
- details of all parties to the transaction: payer, issuing bank, executive organization, recipient of funds;
- type of letter of credit;
- validity period;
- a list of documents to be provided by the recipient of the funds, requirements for them and the final date of their submission;
- method of execution of the letter of credit;
- purpose of this payment;
- consignor, consignee, destination of cargo;
- closing date of the money transfer process;
- commission percentage of banks from the transaction and the procedure for its payment.
This is a list of basic information, but the document may contain any information of interest to the applicant. More detailed information is contained in the Regulation of the Central Bank of the Russian Federation of June 19, 2012 N 383-P “On the rules for the transfer of funds” (paragraph 6.7).
Ways to execute letters of credit
There are several methods that banks use to pay for a bank transfer transaction:
1. Payment after the seller has provided the necessary documents.
2. Delay in payment: carried out a few days after the bank receives the agreed list of documents or a certain period after the shipment of the goods.
3. Mixed payment: part of the amount is paid upon presentation of documents, part - a few days after shipment.
4. Acceptance of a bill of exchange: it is accepted by the issuing bank or contractor and paid on time.
5. Negotiation of documents: the executing bank buys a bill of exchange (draft), issued at a completely different bank, or documents by advance payment to the beneficiary (seller) or a promise to pay an advance before the banking day, on which the bank should receive a refund from the issuing bank . This method is used when the owner of the goods wants to receive money immediately, and the buyer wants to pay wholesale some time after receiving it.
Advantages of Bank Obligations
Settlements by letters of credit are financial transactions that have a number of advantages, namely:
- assignment of responsibility to commercial organizations for the legality of money transactions in the form of a letter of credit;
- full payment to the seller;
- returning the full amount to the buyer in case of cancellation of the sale;
- full compliance with the terms of the contract between the parties due to banking control;
- preservation of customer funds within the organization.
Cons of settlements through a letter of credit
In addition to the positive aspects, these payment orders have some disadvantages, namely:
- at each stage of the transaction it is necessary to provide a large number of documents;
- the high cost of this non-cash payment for both parties.
Despite the inconveniences that exist with this form of payment, settlements by documentary letters of credit guarantee the success of the transaction, ensure its transparency and legality, and also allow the bank's customers to find new business partners and make relationships open, successful and promising.