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An irrevocable letter of credit is a product banks offer to their corporate customers to provide business financing. It is used to secure payment between a buyer and seller. The uncommon revocable letter can be modified by the bank without notifying the parties involved. The more common irrevocable letter of credit can only be modified when all parties involved agree to the modification. There are two types of irrevocable letters of credit: a standby letter of credit and a documentary letter of credit.
Purpose of an Irrevocable Letter of Credit
Irrevocable letters of credit are used for two primary reasons: to facilitate international transactions and to secure payment when a seller is unwilling to offer trade credit to a customer. Doing business internationally often involves more risk than domestic transactions. Different business cultures, legal requirements and political landscapes may oblige the seller to insure payment with a letter of credit. The second reason a seller may request a letter of credit is when a buyer’s creditworthiness does not meet the seller’s minimum criteria for trade credit. In this case, the letter of credit is a guarantee that the customer’s bank will pay balances owed should the customer fail to do so.
Parties Involved in Irrevocable Letters of Credit
There are three primary parties involved in the issuance of an irrevocable letter of credit: the issuing bank, the beneficiary and the applicant. A fourth party might be the advising, or confirming, bank. The beneficiary is the seller. The buyer is the applicant. When a seller (beneficiary) requires a buyer (applicant) to obtain a letter of credit, the buyer will ask its bank (issuing bank) to issue a letter of credit guaranteeing the amount of the transaction. The beneficiary may ask its bank (advising bank) to review the letter of credit. If the advising bank guarantees a portion of the transaction, it becomes the confirming bank.
Standby Irrevocable Letter of Credit
As its name indicates, a standby irrevocable letter of credit is used to “stand by” in case of default by a company’s customer. This type of letter of credit is used by some companies to establish a good payment pattern for new customers. It is also used when a customer fails to meet the minimum criteria for a line of credit. Standby irrevocable letters of credit require minimal documentation, usually a one-page letter from the bank to the beneficiary.
Documentary Irrevocable Letter of Credit
A documentary irrevocable letter of credit is most commonly used for international transactions. It typically covers only one transaction. The details of the transaction are specified in the document. Details may include product description and amount, departure and arrival dates, and payment terms.
How to Establish an Irrevocable Letter of Credit
Once a seller has requested that the buyer obtain a letter of credit, the first step is to contact the bank. The banker should be familiar with the Uniform Customs and Practice for Documentary Credits (UCP). The banker may request collateral for the letter of credit. However, most customers will have already established a line of credit with the bank, and the irrevocable letter of credit can be held against this line. Once the beneficiary, issuing bank and customer all agree to the terms of the irrevocable letter of credit, the customer can proceed to do business with the seller.
Sara Huter is a professor of economics. Her background also includes risk management in the banking and energy industries with expertise in credit scores. Huter received an M.B.A. in finance from Texas A&M University and a B.S. in information systems from Kansas State University. She has been writing for over five years with work at Popsyndicate.com, WickedWordSmith.com and Simplejoy.com.