A letter of credit is a formal document issued to a seller by a financial institution on behalf of a buyer, guaranteeing that the bank pays the seller for the goods or services rendered. The bank plays an intermediary role and substitutes the creditworthiness of the buyer. It verifies that the documentation of goods sold meets the terms of the credit letter and issues payments to the seller, reports the Houston Chronicle.
A letter of credit is used in newly established trade relationships or other high-risk business situations where the creditworthiness of the buyer's bank satisfies the seller more than the buyer's creditworthiness, notes Export.gov. The letter spreads the transactional risk between the buyer and the seller. A letter of credit is useful because it allows the buyer to pay for products after shipment and avails a variety of financing options. However, using a letter of credit is a labor intensive process that attracts high transaction costs.
The bank that issues a letter of credit has an obligation to pay the seller when he satisfies the terms of the letter. The bank only deals with documentation and does not ascertain the status of the goods supplied. A letter of credit may take many forms, including a transferable, revolving and standby letter of credit, states Export.gov.