What is a letter of credit discounting?

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What is a letter of credit discounting?
Letters of credit facilitate international trade. (Jupiterimages/Photos.com/Getty Images)

A letter of credit is a promise to pay. LCs (also abbreviated to L/Crs) are usually used for international trade. The LC is a contract that says the shipper will be paid by the buyer’s bank on receipt of goods. The shipper must present proof of delivery and then the bank will release the approved amount. This process causes a delay in payment between the departure of the goods from the seller and the arrival at the buyer’s premises in a foreign country. Banks and financial institutions will buy LCs at a discount.

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Factoring

Letter of credit discounting is a form of factoring. Factoring has been a standard banking service since banks began. The bank agrees to buy the debt owed to a company off them but will pay less than the face value of the invoices that prove the debt. The reputation if the buyer who has yet to pay those invoices affects the saleability of the debt and the amount of discount subtracted from the value. The business takes a cut in the amount it expects to receive in exchange for immediate payment. The bank is prepared to wait for payment because the discount means it is earning interest on the invoice amount.

Letter of credit discounting

British banks understand letters of credit well, the issue them and process them frequently for customers that engage in import and export. However, they will not buy the LCs off you until the confirming documents are presented. The major delay in getting paid on LCs is the shipping period. In theory, as soon as the goods received note is signed, the bank should pay out on the full value of the LC. Unfortunately, there can often be further delays caused by the bank processing a completed LC and its is this period that third party banks are prepared to buy the LCs at a discount.

Loans

If the shipper is a regular customer of a bank and if the buyer is a well known international company with a good track record of paying promptly on LCs, your bank may be prepared to lend you money on an LC as soon as the goods are shopped. However, this is not discounting. For the business, paying interest on a bank loan incurs the same cost as deducting a discount from a sold LC. Thus lending secured on LCs is often preferred to selling the LCs at a discount because the former allows the business to recycle proceeds faster than the latter.

Pitfalls

Not all LCs are equal and some countries and some companies gain reputations for not paying for goods contracted through LCs. It is a good idea to check with a bank on the discount rate for LCs written by a specific bank for your potential customer. Large international banks have experience of those buyers who habitually fail to pay on LCs. Recovering unpaid bills in a foreign country is difficult and expensive and. Unless the sums involved are very large, most exporters don’t bother. If the bank tells you that LCs of your potential customer are not investment grade, don’t make the sale. That customer is going to fleece you.

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