What it means
A letter of credit is a written promise from a buyer's bank to pay a seller, provided the seller presents the documents the contract requires. These documents typically include the invoice, shipping papers and an inspection certificate.
It replaces trust between two strangers with trust in a bank. A confirmed letter of credit adds a second layer.
A bank that the seller knows and trusts, called the confirming bank, adds its own undertaking to pay once the documents comply. The seller is then protected against two things: the issuing bank defaulting, and political or currency problems in the buyer's country.
Confirmation costs money. The confirming bank charges a fee that depends on the risk of the issuing bank and its country, and the buyer or the seller pays it depending on what was agreed in the sales contract.
Exporters tend to ask for confirmation when selling to buyers in countries or banks they regard as higher risk. The most important practical point is that payment depends on the documents, not the goods.
If the paperwork has a mistake, such as a wrong date or a mismatched description, the bank can refuse to pay even though the shipment arrived in perfect condition. Careful document checking is therefore central to the process.
Letters of credit are usually governed by internationally accepted rules published by the International Chamber of Commerce, which give banks and traders a common standard. Even so, the terms of each credit are individual, so exporters should read them before shipping and ask for amendments if anything cannot be met.
In practice
Real-world examples.
Example
A furniture maker in Vietnam sells $300,000 of goods to a new buyer in a country with strict currency controls. She asks for a letter of credit confirmed by a large international bank. Her payment no longer depends on whether the buyer's government allows money to leave the country.
Example
A coffee exporter agrees a first sale with a buyer he has never met, and the buyer's local bank is small and little known. He insists on confirmation by a bank in his own country. The extra fee is built into the price, and he ships with confidence.
Example
A machinery importer in Africa wants to win a supplier's trust for a $1,200,000 order. She offers to pay for confirmation so the supplier will accept the order without a deposit. The supplier agrees, and the importer keeps its cash for operating costs.
Formula
Calculation
Confirmation fee = Credit amount x Confirmation fee rate x (Period in months / 12) in the simple case where the fee is quoted as an annual rate.
Suppose an exporter ships machinery worth $500,000 under a letter of credit and the confirming bank quotes an annual rate of 0.75% for a 6-month period.
Confirmation fee = 500,000 x 0.0075 x (6 / 12) = 500,000 x 0.0075 x 0.5.
500,000 x 0.0075 = $3,750 for a full year, and half of that is $1,875.
The exporter therefore pays $1,875 to remove the risk that the issuing bank or its country fails to pay $500,000. That is 0.375% of the contract value for 6 months of cover.Case study
Seen in the real world.
Silverline Textiles is a fictional garment exporter used here for illustration. It received an order worth $250,000 from a buyer in a market where banks had recently struggled with foreign currency shortages. The buyer offered an unconfirmed letter of credit from a local bank.
Silverline's finance manager, Amara, asked for confirmation by a bank in her own country and agreed to split the fee with the buyer. The confirmation fee was about $1,250, which was small next to the amount at risk.
Several weeks after shipment, the issuing bank delayed payment because of currency restrictions. Because the credit was confirmed, the confirming bank paid Silverline on time against compliant documents and then pursued the issuing bank. In this illustrative case, the fee protected the whole shipment.
Watch out
Common mistakes.
- Assuming confirmation guarantees payment whatever happens. The confirming bank pays only if the documents comply exactly with the terms of the credit.
- Ignoring who pays the confirmation fee. If the sales contract is silent, a dispute can arise, so the payer should be agreed before the credit is opened.
- Confusing a confirmed credit with a credit advised by a bank. An advising bank only passes the credit on, whereas a confirming bank adds its own promise to pay.
Questions
People also ask.
What is the difference between a confirmed and an unconfirmed letter of credit?
In an unconfirmed credit only the issuing bank promises to pay. In a confirmed credit a second bank also promises to pay.
Who usually asks for confirmation?
The seller or exporter, because they carry the risk of non-payment. They tend to ask when the issuing bank or its country looks risky.
What happens if the documents contain an error?
The bank may refuse payment, which is called a discrepancy. The seller can try to correct the documents or ask the buyer to accept them.
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