Letters of Credit come in different types. Essentially there are revocable and irrevocable L/Cs, as well as unconfirmed and confirmed L/Cs. We discuss these different types of L/Cs in the sections below.
Seldom found in international trade today, revocable letters of credit were quite common some thirty years or so ago when trading with developing countries. A revocable letter of credit allows the issuing bank (usually upon request by the importer) to amend or cancel the letter of credit without consent from the exporter or without notice even being given to the exporter. Clearly, there is little or no security of payment in a revocable letter of credit and today you should not be prepared to accept such a form of documentary credit. The words, “this credit is subject to cancellation without notice”, “revocable documentary”, or “revocable credit” will normally be stated on this form of letter of credit.
An irrevocable letter of credit requires the consent of the issuing bank, the exporter (the beneficiary) and importer (the applicant) before any amendment, modification or cancellation to the original terms of the L/C can be made. This type of letter of credit is commonly used in trade today and is preferred by exporters because payment is always assured, as long as the supporting documents submitted by the exporter comply with the terms specified in the letter of credit. Irrevocable letters of credit can be both confirmed and unconfirmed
In the case of an unconfirmed L/C, the documentary credit bears the guarantee of the issuing bank alone. The advising bank (in your home country) merely informs the exporter of the terms and conditions of the letter of credit, without adding its obligation to pay. The exporter thus assumes the payment risk of the issuing (foreign) bank. Should the issuing bank go bankrupt or should political problems arise between the countries in question, and the issuing bank does not honour its obligation, you as the exporter have no guarantee of payment
If one is doing business with a reliable country and if the issuing bank is a reputable bank, then most exporters will be willing to accept an unconfirmed irrevocable letter of credit. Nevertheless, you may still wish to take out export credit insurance as protection against the possible insolvency or default of the issuing bank or foreign country in question, and you should definitely consider such insurance in the case of suspect banks/countries
This is one of the most secure forms of payment and works in the same way as the irrevocable documentary credit we described in the previous section, except that a second-level of guarantee is offered to the exporter by another bank (this other bank is usually the advising bank, although it could be any local bank or even a reputable foreign bank). This second bank gives its undertaking and commitment (i.e. its “confirmation”) to pay the exporter, even if the issuing bank defaults for whatever reason. In this instance, this bank (be it local or foreign) is also known as the confirming bank. The confirming bank normally expresses its confirmation in a covering letter to the exporter. Confirming an L/C may be done on the request of the exporter, but it is more often a requirement of the L/C as negotiated between the exporter and importer, in which case the importer may ask the issuing bank to in turn ask the advising bank to confirm the L/C. It is not always the case that a bank will confirm an L/C; they may refuse to do so if they consider the issuing bank or the importing country to represent a high risk for them. Without such notification, no confirmation has taken place.
If you are not happy getting the L/C confirmed by the issuing bank in the instance where the issuing bank is not your local bank, you could consider having the L/C verified by your own bank. By “confirming” the letter of credit, your own bank will agree to pay you even if the issuing bank (i.e. the importer’s bank) defaults. Your bank will charge a commission based on the creditworthiness of the issuing bank. Although this option may cost you extra money, you can at least rest assured that the L/C carries little credit risk. Whatever option you decide to follow, you will still need to ensure that your documentary evidence is accurate and in keeping with the requirements of the L/C, before the issuing bank will pay via their advising bank you within the stipulated time.
Exporters who have a confirmed irrevocable letter of credit generally do not need the additional protection of export credit insurance. From the exporter’s point of view, the irrevocable confirmed letter of credit is the most secure kind of letter of credit for the following reasons:
- It has the commitment of two banks to pay
- The exporter is protected against the risk of non-payment by the importer
- The exporter is protected against the risk of the foreign government restricting the transfer of foreign exchange to the exporter’s country