What Is a Confirmed Letter of Credit?
The term confirmed letter of credit refers to an additional guarantee to an original letter of credit obtained by a borrower from a second bank. It guarantees that the second bank will pay the seller in a transaction if the first bank fails to do so. Borrowers may be required to get a confirmed letter of credit if the seller has doubts about the creditworthiness of the bank that issued the initial letter. Requiring a confirmed letter of credit decreases the risk of default for the seller.
Key Takeaways
- A letter of credit is a guarantee from a bank that it will make good on a buyer's financial obligations to a seller in a transaction.
- A confirmed letter of credit is a guarantee from a second bank that it will pay the seller if the first bank fails to do so.
- The confirmed letter decreases the risk of default for the seller.
- Confirmed letters of credit are most often used in international trade and business transactions where a lot of money is at stake.
How Confirmed Letters of Credit Work
Letters of credit are most commonly used in international trade and in business transactions that require substantial payment for goods or services. Instead of requesting an advance payment, the seller may require the buyer to obtain a letter of credit for the balance of the payment owed at the time of delivery. This letter acts as a guarantee from the buyer's bank that payment will be made on time and for the full amount. If the buyer fails to live up to their obligation as outlined in the contract, the bank takes on the responsibility of covering any remaining debt. Letter of credit are typically valid for a limited period, such as 90 days.
A seller may require a second, or confirmed, letter of credit if it is not satisfied with the creditworthiness of bank that issued the first letter of credit, or the issuing bank may itself request one. In many cases, the second bank will be the seller's bank. The second bank promises to pay the seller the amount agree to if the first bank fails to do so.
The process of securing the second letter of credit is the same as for the first one. The buyer must find a second bank to back its purchase in case of default. The structuring of the funds for the second letter of credit generally takes the terms of the first letter of credit into consideration as well. In some cases, the seller may only require the second letter of credit represent a percentage of the total due.
As with the first letter of credit, banks may charge the buyer a fee when they issue a confirmed letter of credit. The amount of the fee can depend on the size of the transaction and payment amount, as well as the relationship between the buyer and the bank. In many cases, the bank may ask the buyer to put up securities or cash as collateral in exchange for issuing the letter. Confirming letters add to the cost of the transaction but reduce its risk.
The same bank cannot issue both the first and confirmed letters of credit.
What Is an Unconfirmed Letter of Credit?
When the seller is satisfied with the buyer's first letter of credit they may simply accept it. That's what's known as an unconfirmed letter of credit. Unconfirmed letters of credit require the backing of only one bank.
Advantages of Confirmed Letters of Credit
Just like a (first) letter of credit, the confirmed or second letter of credit has advantages for both the seller and the buyer by protecting both their interests. The letter gives the seller assurance that it will receive payment after the goods and/or services are delivered to the buyer. As mentioned above, if the buyer doesn't pay, the bank assumes responsibility for the payment.
By getting a second letter, the risk of default drops, since another bank agrees to pay if the first one isn't able to do so. Buyers can generally rest assured that they will receive the requested goods and services from the seller when they obtain a confirmed letter of credit for their purchase. In addition, by using a letter of credit, confirmed or not, they will not have had to pay cash in advance.
Example of Confirmed Letter of Credit
Here's a hypothetical example of how confirmed letters of credit work. Let's say Company A purchases supplies from Company B, which operates in a different country. In order to facilitate the transaction, Company B requires a letter of credit from the buyer's bank. Company A receives one from its bank and sends it over to the seller. Because the issuing bank of the first letter of credit is in a different country and its creditworthiness is not known, Company A tells the buyer that it needs a second letter of credit from another bank in order to complete the transaction. The buyer applies for the second letter with the seller's bank. This will likely satisfy the conditions of the sale, especially because Company B already has a relationship with that bank.
How Do You Obtain a Confirmed Letter of Credit?
Buyers must work with their banks to secure a letter of credit. This requires a full credit application—the same as if the buyer was applying for a loan. The terms of the letter will typically structure any payment the bank may have to make as a loan to the buyer, including a stated interest rate and repayment schedule.
What Is a Revolving Letter of Credit?
A revolving letter of credit is one that covers a series of transactions between a particular buyer and seller over a period of time, rather than just a single transaction.
What Is a Commercial Letter of Credit?
With a commercial letter of credit, the issuing bank makes payment directly to the seller
The Bottom Line
Confirmed letters of credit are useful in international commerce and other contexts when a seller needs to be certain that it will receive full payment for its goods or services. They add to the cost of the transaction but, at the same time, reduce its risks.
