Lesson 1 of 8 · Level 1 · Basics
A bank's promise
What a letter of credit really is, who the people in it are, and why a bank's promise on paper lets strangers on two continents trust each other.
Remember Evelyn from the How trade works room? She runs a garment factory in Gazipur. A buyer in Hamburg wants 20,000 T-shirts. She has never met him. He has never seen her factory.
Evelyn thinks: "If I ship first, will he pay?" The buyer thinks: "If I pay first, will the shirts ever come?" Both are right to worry. Neither will move first.
So they bring in someone both of them trust: a bank. The buyer's bank writes Evelyn a promise: "Ship the shirts, bring us the right papers on time, and we will pay you." That promise is a letter of credit, or LC. In this lesson we open it up and look inside.
In plain words
An LC has its own cast, each with a formal name you will meet again and again:
- Applicant: the buyer (importer) who asks his bank to open the LC. Here, the buyer in Hamburg.
- Beneficiary: the seller (exporter) who will be paid. Here, Evelyn.
- Issuing bank: the buyer's bank that opens the LC and makes the promise to pay.
- Advising bank: a bank in the seller's country (often Evelyn's own bank in Dhaka) that checks the LC appears genuine and passes it to her. Advising alone is not a promise to pay.
- Confirming bank: a bank that adds its own promise to pay, on top of the issuing bank's, at the issuing bank's request. Useful when the seller worries about the issuing bank or its country.
- Nominated bank: the bank named in the LC where the seller can present documents and may get paid. Sometimes any bank can play this role.
One bank can wear more than one hat. Evelyn's bank, for example, may advise the LC, confirm it if asked, and act as the nominated bank too.
In everyday life
Picture renting your flat to a new tenant who works abroad. His employer writes you a letter: "We will pay his rent from his salary" (the issuing bank's promise). Your cousin, who knows that company, checks the letter is real and hands it to you, but promises nothing himself (the advising bank). If your well-off mama adds, "And if they don't pay, I will" (the confirming bank), you now hold two promises. You sleep better.
Key words
- Applicant
- The buyer (importer) who asks a bank to open an LC.
- Beneficiary
- The seller (exporter) in whose favour the LC is opened, and who will be paid under it.
- Issuing bank
- The buyer's bank that opens the LC and promises to pay against the right documents.
- Advising bank
- A bank in the seller's country that checks an LC appears genuine and passes it to the seller, without promising to pay.
- Confirming bank
- A bank that adds its own promise to pay to an LC, on top of the issuing bank's promise.
- Nominated bank
- The bank named in the LC where the seller may present documents and be paid.
Part 3A promise that stands on its own
In plain words
Evelyn and the buyer have a sales contract. The LC is born from that contract, but once it is issued, it stands on its own.
The bank's promise depends only on the LC's own terms. It does not depend on what the contract says, on any quarrel between buyer and seller, or on whether the buyer is now happy with the deal. Even if the LC mentions the contract, the bank is not bound by the contract.
Why? Because a bank can't judge every trade dispute in the world. If buyers could stop payment by saying "I'm not happy with the seller", the promise would be worth very little, and no seller would trust it.
For the same reason, the LC's terms must be clear and complete. Whatever the buyer truly needs (the latest shipment date, the documents, the inspection certificate) must be written into the LC, not left in the contract.
In everyday life
Say you buy a bus ticket from Dhaka to Sylhet. On the way, you argue with the passenger next to you about the window seat. The bus company still owes you the trip: your ticket is a promise between you and the company, separate from any quarrel on the bus.
Key words
- Sales contract
- The agreement between buyer and seller on goods, price, delivery and payment.
- Independence principle
- The idea that an LC is separate from the sales contract: the bank's promise depends only on the LC's own terms.
In plain words
Here is the idea that surprises most beginners: banks deal in documents, not in goods.
The bank never opens a carton or counts T-shirts. It checks the papers: the invoice, the bill of lading, the packing list, the certificate of origin, and whatever else the LC asks for. If the papers, on their face, fit the LC and don't conflict with each other, the bank pays.
This cuts both ways:
- Good for Evelyn: if her papers are right, she gets paid, even if the buyer later grumbles about the colour.
- A warning for the buyer: the LC protects him only as far as the documents go. If he wants proof of quality, he must ask for it in the LC, for example an inspection certificate from a named company.
In rare cases of proven fraud, courts in many countries can step in and stop payment. That is the exception, not the rule.
In everyday life
An exam board marks your answer script, not your brain. If you knew everything but wrote the wrong roll number, the script still has a problem. If your answers on paper are right, you pass, even if you were nervous inside. Banks are exam boards for trade papers.
Key words
- Bill of Lading (B/L)
- Shipping document for sea cargo: the carrier's receipt for the goods and, when negotiable, the document of title that lets the holder claim them.
- Inspection certificate
- A report from an independent company that checked the goods' quantity or quality before shipment.
- Discrepancy
- A difference between the documents and the LC terms, or between the documents themselves. It can delay or stop payment.
Putting it together
So far: an LC is a bank's written promise to pay the seller against the right documents, on time. It has its own cast (applicant, beneficiary, issuing, advising, confirming and nominated banks). It stands apart from the sales contract, and banks deal in documents, not goods. It costs fees and care, and in return strangers can trade with confidence.
Next: we follow one LC through its whole life, from the buyer's application to the day the money reaches Evelyn.