Risk Management in Letter of Credit (2024)

A letter of credit (LOC) is issued by a bank to guarantee payment to a seller from a buyer. An LOC comes with its own set of requirements that entitle the seller to this payment. If a buyer fails to pay, the bank would cover the amount needed to pay the seller. This way, the bank acts as the payment's guarantor. When an LOC's requirements are met, payment would always be credited to the seller, ensuring that these sellers would not experience loss of income.

In international trades, a letter of credit is useful as rules and laws of each country can be different. For example, the time and process needed to credit payments may vary. This way, a letter of credit serves as an agreement that as long as terms are upheld and followed, payment would be credited on the agreed time.

There are, however, some drawbacks of using a letter of credit as a means to receive international payment:

While banks will always try their best to make sure that every party’s background is checked, frauds could still take place. Fake documents are not new and sometimes these can be used by irresponsible parties when making their case to the bank issuing the LOC.

If, for example, these documents are passed through by the bank as they look to be in compliance with the LOC’s terms and requirements, the bank will honor the LOC. As a result, the applicant of the LOC still have to pay the issuing bank despite the goods/funds that they would never receive.

Tailored solutions and more customed approaches like special guarantees/standby LOCs could help your business get the payment it deserves. Especially useful when dealing with a new partner that you have not established a relationship with, a guarantee enables you to negotiate favourable payments while fulfilling your financing needs.

Some of these may even include up-front payments and performance definition to reduce the risk of fraud. Whether as a supplier or a buyer, your business is now better protected.

To take up forfaiting is to protect your business and manage risks at the same time, while not hindering your ability to finance it. Through imports and exports forfaiting, you can improve your financial statements and limit risks at the same time.

This way, your business can stay ahead of its competitors while having its financing needs secured. As a seller, you do not need to wait longer for payment. As a buyer, obtain financing at a lower cost - this will help you get the goods that you need now while paying the seller at a later date. Early payment means you get a fair, current exchange rate than having to worry about fluctuations at a later date.

Now that you have taken a more thorough look into LOCs and approaches you can take to manage their risks, contact your bank to find out if they can help you. Elaborate what you need to grow your business. Discuss your needs with them to see what your best solutions are.

Once an approach is determined, take the next step and open an account with them. A good bank with great sets of open financing solutions can help you optimise your business’ working capital, reduce costs, and gain better control and visibility over your receivables.