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Problems with letter of credit

Problems with letter of credit

Capital is one of the most important aspects that ensure an organization’s steady growth. The company is pretty much non-existent in absence of sufficient capital. It plays a significant role in supporting the company to accomplish its objectives. However, often times, companies or even a lay person does not have sufficient capital they require to make noteworthy purchases by themselves. This is the part where ready-to-use credit comes handy. Credit undoubtedly helps companies secure the financing they need to attain its vision.

Financial institutions such as banks have set measures in place to gauge a company’s ability to be worthy of receiving the letters of credit. In other words, banks support buyers during times when they are unable to pay their own credit, which in turn assures sellers as there is a sense of guaranteed payment. The seller is made aware that if the buyer does not come through with funds, the bank will. This form of lending or borrowing funds has gained immense popularity in the business market. Letters of credit have allegedly been estimated to represent nearly US $100 billion in banking obligations annually. More than half of the trading that takes place in the commodity sector is conducted through letters of credit. Of course, how much credit is issued entirely depends upon the policies established by banks as well as the situation that the buyer is in. Just like any other form of borrowing method, letters of credit also has its share of risks and troubles. While banks have measures in place to ensure absolute transparency, research suggests that up to 80 per cent documents presented to banks by buyers contain discrepancies. The 80 per cent figure has remained unfazed for the last 17 years of letters of credit’s existence.

Difficulties and problems with Letters of Credit

  • It is difficult to get technical check assistance in letter of credits and it becomes questionable when it comes to small Letters of Credit if they are profitable or not for traders;
  • It is doubtful if they are 100% self liquidating;
  • More risks are attached with specific countries that banks are now prevented from dealing with whereas LC’s are not;
  • LCs are more seen as a mode of payment and as a guarantee of payment;

LC’s are seen as a revocable instrument. This can be due to the poor drafting and governing law and clauses added with it. The following points are not covered in letter of credit;

  • The LC does not reflect the commercial reality of today’s market.
  • Agents of LC sometimes accept L/Cs from buyers without even understanding the cost and risk involved with their business.
  • Difficult terms are involved that may lead to delay and can increase resultant costs through the requirement.
  • Information along with the terms and conditions is needed to be efficiently shared amongst all the parties involved in the process.
  • It may be difficult to deal with a bank for availing LCs and along with this inexperienced document checkers can raise issues

Following given are some of the risk factors that involves letters of credit:

POLITICAL RISKS

Majority of the trades these days tend to have an international link. According to a report published by The Economic Times, India’s total outward shipments in the financial year 2017-2018 was approximately $303.5 billion. Considering that the World Trade Organization had only recently cut the global trade forecast by 2.6 percent, the $303.5 billion amount is considered to be quite a healthy number. From the perspective of globalization, this is absolutely good news. At the same time, since international trade involves factors that take place outside an importer/exporter’s control, this can be quite a risk affecting letters of credit. These factors include a change in the trade regime, civil war, mass riots, transfer risks, currency control systems and sovereign risks to name a few.

FRAUD RISKS

Besides restrictions that occur due to geographical differences, international trade also consists of fraud risks. In comparison to international trade, domestic trade does not represent as high a fraud risk as the former. Further, businesses that involve a bigger transaction also tend to pose a danger in terms of compensating losses quickly. Also, let’s not forget that fraudulent companies disappear before one can reach them legally. Since banks tend to only deal with documents and not goods, services or performance of the buyer or seller’s company, this feature tends to become the major source of fraud risk for the bank.

RISKS FOR APPLICANTS

Applications in this case are considered to be the importer in a commercial letter of credit transaction. There are numerous reasons as to why applicants are subject to facing risks such as risks related to shipments, shortcomings of the issuing bank and fraud-related risks. When we talk about risks related to shipments for applicants, factors such as shorter shipments, late shipments and shipments of low quality goods top the list. Shortcomings of the issuing bank involve factors such as failure to pay the L/C amount. In this case, the applicant may be required to pay the credit amount to the beneficiary, which is an unforeseen circumstance that the applicant may or may not be prepared for. Applicants tend to face fraud-related risks that most commonly stem from the acts of the beneficiaries that float forged documents.

RISKS FOR THE BENEFICIARY

When involving letters of credit, beneficiary is referred to the party in whose favor a credit has been established. Some of the top factors comprising risks for the beneficiary include discrepant document risks, fraud-related risks and non-payment risks. If the bank is able to recognize in time that the documents provided are discrepant, then no party gets adversely affected. However, there are times when banks might take time to figure out the discrepancy involved, which poses a major threat to the beneficiary.

Above mentioned risks are just a few of the many categories of risks involving letters of credit for all parties. Therefore, it is vital that there are no compromises made when it requires one to follow appropriate banking policies and regulations. An overall understanding of one’s business is also essential, so that letters of credit work for you rather than against you.