Letters of Credit | Deferred Payment Guarantee | | PAPER II – PRINCIPLES & PRACTICES OF BANKING | MODULE B: FUNCTIONS OF BANKS

Letters of Credit and Deferred Payment Guarantee

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1. Letters of Credit – General Consideration

A Letter of Credit (LC) is a financial instrument issued by a bank at the request of a buyer, guaranteeing the seller will receive payment upon the presentation of specified documents. It facilitates international trade by reducing payment risks.

2. Parties to a Letter of Credit

• Applicant: Buyer who requests the LC.
• Beneficiary: Seller in whose favor the LC is issued.
• Issuing Bank: Bank that issues the LC on behalf of the applicant.
• Advising Bank: Bank that informs the beneficiary about the LC.
• Confirming Bank (optional): Bank that adds its confirmation to the LC.
• Negotiating Bank: Bank that negotiates documents under LC.

3. Types of Letters of Credit

• Revocable LC: Can be amended or canceled without consent of the beneficiary.
• Irrevocable LC: Cannot be amended or canceled without consent.
• Confirmed LC: A second bank guarantees payment.
• Sight LC: Payment is made on presentation of documents.
• Usance LC: Payment is made after a specified period (e.g., 90 days).
• Transferable LC: Can be transferred to other beneficiaries.

4. Documents Under a Letter of Credit

Documents required typically include:

• Bill of Lading
• Commercial Invoice
• Certificate of Origin
• Packing List
• Inspection Certificate
• Insurance Document

5. Uniform Customs and Practices for Documentary Credits – UCPDC 600

The UCPDC 600 is a set of standardized rules published by the International Chamber of Commerce (ICC) for the use of documentary credits. It ensures consistency in international trade finance.

6. Payment Under Letter of Credit – Primary Obligations of Banks

The issuing bank must honor the payment obligation if the beneficiary presents documents that strictly comply with LC terms. The banks deal only in documents, not goods or services.

Example:

ABC Ltd. (India) imports machinery from XYZ Corp. (Germany) worth $100,000. ABC Ltd. requests its bank to open an irrevocable LC. Upon shipment, XYZ presents required documents. The issuing bank verifies and pays $100,000.

Mathematical Illustration:

Total LC Value = $100,000
Usance Period = 90 days
Interest Rate = 6% per annum

Interest = (100,000 × 6 × 90) / (100 × 365)
         = $1,479.45

Effective amount after 90 days = $100,000 + $1,479.45 = $101,479.45
  

7. Deferred Payment Guarantee (DPG)

A DPG is a guarantee issued by a bank to ensure payment is made by the buyer at a future date for goods purchased on credit. It is similar to term loans and used in capital goods purchases.

Purpose of Deferred Payment Guarantee:

• Support for import of capital goods.
• Assures supplier of payment over an agreed term.

Method of Payment:

The buyer pays in installments as agreed (e.g., quarterly). The bank honors the payment in case of default, and then recovers from the buyer.

Example:

ABC Ltd. buys machinery worth ₹50 lakh under DPG for 2 years with quarterly installments. If ABC Ltd. defaults, the bank pays the seller and recovers the amount.

Mathematical Illustration:

Loan Amount = ₹50,00,000
Tenure = 2 years (8 quarters)
Interest Rate = 8% p.a. (simple interest)

Quarterly Interest = (50,00,000 × 8%) / 4 = ₹1,00,000
Quarterly Installment (Principal only) = 50,00,000 / 8 = ₹6,25,000

Total Quarterly Payment = ₹6,25,000 + ₹1,00,000 = ₹7,25,000
  

MCQs – Letters of Credit and Deferred Payment Guarantee

1. Which party issues a Letter of Credit?
   a) Buyer
   b) Seller
   c) Issuing Bank ✅
   d) Advising Bank
2. Which document is not commonly required under a Letter of Credit?
   a) Commercial Invoice
   b) Passport ✅
   c) Bill of Lading
   d) Certificate of Origin
3. The UCPDC 600 is issued by:
   a) RBI
   b) WTO
   c) International Chamber of Commerce ✅
   d) IMF
4. A Letter of Credit is mainly used in:
   a) Domestic Transactions
   b) Government Grants
   c) International Trade ✅
   d) Mutual Funds
5. A DPG is generally used for:
   a) Working capital finance
   b) Purchase of raw materials
   c) Import of capital goods ✅
   d) Export incentives
6. Which party receives the payment under LC?
   a) Issuing Bank
   b) Confirming Bank
   c) Beneficiary ✅
   d) Applicant
7. DPG is closest in nature to:
   a) Demand Draft
   b) Term Loan ✅
   c) Credit Card
   d) Bank Guarantee for Tender
8. Which LC type allows transfer to another beneficiary?
   a) Revocable
   b) Transferable ✅
   c) Confirmed
   d) Usance
9. Interest calculation on a usance LC is based on:
   a) Days between presentation and due date ✅
   b) Date of issue
   c) Shipment date
   d) Invoice date
10. Who bears the obligation if buyer defaults under DPG?
    a) Supplier
    b) Buyer
    c) Advising Bank
    d) Issuing Bank ✅