Letter of Credit
A Letter of Credit (L/C) is a commitment, usually by a bank on behalf of a client, to pay a beneficiary, such as a supplier of goods, a stated amount of money under specified conditions such as on shipment of the specified goods. It is a form of financial guarantee covering the buyer's risk and guaranteeing payment to the seller; the bank will only make payment upon presentation of the shipping and other stipulated documents, which complies with the terms and conditions of the L/C.
L/Cs are widely used in financing foreign trade to guarantee payment to a supplier after shipment is effected. They carry a risk for the issuing bank in case the bank makes a payment under the L/C and the client defaults. Therefore, before issuing a L/C, the bank assesses the client’s financial position to determine whether the client’s creditworthiness merits the risk taken by the bank on the client’s ability to pay. The bank may even consider taking a security to minimise any potential loss.
Through L/C in the context of foreign trade, exporters can obtain a quick, secure and guaranteed payment of goods from a bank. The import client of the bank gives a written undertaking in favour of an exporter or a local supplier guaranteeing payment on sight or payable after a determinable period after shipment for purchase of goods from an exporter.
When used by Islamic banks for export/import financing, L/Cs are not treated as a as a guarantee but rather as a fee based banking service to facilitate trade. Islamic banks usually issue L/Cs on the basis of Wakalah, Murabaha or Musharakah. All operations must fulfil the requirements of the Shari´ah. The processing of L/Cs usually involve two banks, the L/C opening bank and the correspondent bank to whom the L/C is sent for advising the exporter.
When using the Wakalah concept, the bank acts as the agent of the importer; he deposits with the bank the full amount of the L/C to cover the import transaction and the bank opens the L/C; after shipment of goods and submission of stipulated documents by the exporter, the bank makes payment using the client’s deposit. The bank charges a fee/commission (Ujrah) for its services. In the case on LC using Murabaha, the procedures of Murabaha still apply except that payment to the bank is not deferred. In fact, the Islamic bank opens the L/C and, after shipment of goods and submission of stipulated documents, it makes payment to the exporter, using the bank’s own funds; It takes delivery of the goods on arrival and sells the imported goods to the client; the bank recovers its cost and gets a small commission for services rendered as an agent. The client repays the bank on a deferred basis as agreed. In the case of a Letter of Credit with Musharakah, the client deposits with the bank an agreed share of the cost of the imported goods, representing the client’s share in the transaction. After shipment of the goods and submission of the stipulated documents, the bank makes full payment to the exporter, using the client’s deposit and the bank’s own funds for the balance. After the imported goods are sold at the market price, the bank and the client share the profit at a pre-agreed ratio. The client may also purchase the bank’s share of the imported goods at the market price.
Islamic banks are allowed to charge a handling commission/fee, as a service charge to for processing L/Cs, documentation and payments; the amount various according to the service and to the L/C amount involved. For example, the bank can also charge its client an issuing commission, plus other charges such as postage, an advising fee, or a confirmation fee. These fees are usually not relative to the amount of the L/C and its duration. The bank may also charge an amendment fee in case the exporter requires amendments to the L/C terms. It may also charge a commission for accepting the Bill of Exchange, as it becomes the bank’s obligation to make the payment on the due date.
L/Cs are widely used in financing foreign trade to guarantee payment to a supplier after shipment is effected. They carry a risk for the issuing bank in case the bank makes a payment under the L/C and the client defaults. Therefore, before issuing a L/C, the bank assesses the client’s financial position to determine whether the client’s creditworthiness merits the risk taken by the bank on the client’s ability to pay. The bank may even consider taking a security to minimise any potential loss.
Through L/C in the context of foreign trade, exporters can obtain a quick, secure and guaranteed payment of goods from a bank. The import client of the bank gives a written undertaking in favour of an exporter or a local supplier guaranteeing payment on sight or payable after a determinable period after shipment for purchase of goods from an exporter.
When used by Islamic banks for export/import financing, L/Cs are not treated as a as a guarantee but rather as a fee based banking service to facilitate trade. Islamic banks usually issue L/Cs on the basis of Wakalah, Murabaha or Musharakah. All operations must fulfil the requirements of the Shari´ah. The processing of L/Cs usually involve two banks, the L/C opening bank and the correspondent bank to whom the L/C is sent for advising the exporter.
When using the Wakalah concept, the bank acts as the agent of the importer; he deposits with the bank the full amount of the L/C to cover the import transaction and the bank opens the L/C; after shipment of goods and submission of stipulated documents by the exporter, the bank makes payment using the client’s deposit. The bank charges a fee/commission (Ujrah) for its services. In the case on LC using Murabaha, the procedures of Murabaha still apply except that payment to the bank is not deferred. In fact, the Islamic bank opens the L/C and, after shipment of goods and submission of stipulated documents, it makes payment to the exporter, using the bank’s own funds; It takes delivery of the goods on arrival and sells the imported goods to the client; the bank recovers its cost and gets a small commission for services rendered as an agent. The client repays the bank on a deferred basis as agreed. In the case of a Letter of Credit with Musharakah, the client deposits with the bank an agreed share of the cost of the imported goods, representing the client’s share in the transaction. After shipment of the goods and submission of the stipulated documents, the bank makes full payment to the exporter, using the client’s deposit and the bank’s own funds for the balance. After the imported goods are sold at the market price, the bank and the client share the profit at a pre-agreed ratio. The client may also purchase the bank’s share of the imported goods at the market price.
Islamic banks are allowed to charge a handling commission/fee, as a service charge to for processing L/Cs, documentation and payments; the amount various according to the service and to the L/C amount involved. For example, the bank can also charge its client an issuing commission, plus other charges such as postage, an advising fee, or a confirmation fee. These fees are usually not relative to the amount of the L/C and its duration. The bank may also charge an amendment fee in case the exporter requires amendments to the L/C terms. It may also charge a commission for accepting the Bill of Exchange, as it becomes the bank’s obligation to make the payment on the due date.
