Commercial banks are crucial to international trade. When trading partners are on the other side of the world or in a country where business contracts are difficult to enforce, banks lessen the risks of doing business overseas with financial products like letters of credit.
Bank Issued Letters of Credit
Letters of credit are the most common financial service that commercial banks provide for international businesses. They are typically used for exporting goods to countries where there can be difficulty enforcing contracts or when trading with countries that present a considerable risk. Very few U.S. firms use letters of credit when shipping to Canada, Mexico or most members of the European Union. Letters of credit are most often used when trading with riskier destinations, such as Pakistan, Turkey, India or China. Approximately 30 percent of U.S. exports to China are facilitated with letters of credit from commercial banks.
How a Letter of Credit Works
Once the buyer and the seller have entered into a contract for the sale of goods, the buyer will ask the bank for a letter of credit. The seller’s bank must authenticate the letter of credit before any goods can be shipped. Once the seller ships the goods, it forwards the export documents to their bank. The seller’s bank matches up the export documents with the letter of credit to make sure that what was contracted to be shipped is what was actually shipped. If all the documents agree, the buyer’s bank sends its payment to the seller’s bank.
Funding a Letter of Credit
In most cases a letter of credit is a negotiable instrument, like a bank check, that the issuing bank will pay to the seller. A transferable letter of credit permits the seller to transfer the payment to a third party, such as a corporate parent company. The same way a consumer who writes a personal check for payment of goods must have enough money in the bank to cover her purchase, banks require buyers requesting letters of credit to provide collateral, such as cash or securities, in exchange for issuing a letter of credit.
In addition, banks may levy a service charge that is a percentage of the amount of the letter of credit requested. The service charge often reflects the amount of risk the bank assumes. The riskier the destination, the higher the fees are likely to be. To eliminate risk in some instances, banks will accept only cash paid in advance before shipping.