Letter of Credit LC in Banks

                                    General Concept of FEX business

In International trade, it is very difficult to know the buyer and seller. Thus, the buyer wants to be assured of goods and seller to be assured of payments. Commercial Banks, therefore, assure these things to happen simultaneously by opening letter of credit guaranteing payment to seller and goods to buyer. By opening a letter of credit on behalf of a buyer in favour of a seller, commercial banks undertake to make payments to a seller subject to submission of documents drawn in strict  compliance with letter of credit terms giving title to goods to the buyer.

It is a conditional guarantee.

Definition of LC

In brief, a documentary credit is an undertaking by a bank to pay subject to conformity of the documents to the contractual instruction. According to Shari'ah Standard No. (14) prepared by Accounting and Auditing Organization for Islamic Financial Institution (AAOIFI). A documentary credit is a written undertaking by a bank (known as the issuer) given to the seller (the beneficiary) as per the buyer's (applicant's or order's) instruction or is issued by the bank for its own use, undertaking to pay up to a specified amount (in cash or through acceptance or discounting of a Bill of Exchange), within a certain period of time, on condition that the seller present documents for the goods conforming to the instructions.

In a word L/C is a Letter of 'Undertaking for Payment in general. As per UCP 600 Letter of Credit (L/C) means Documentary Letter of Credit (Credit). 'Credit' means any arrangement, however named or described that is Irrevocable and thereby constitutes a definite undertaking of the Issuing Bank to honor a complying presentation.

'Complying Presentation' means a presentation that is in accordance with the terms and conditions of the Credit.    

  the applicable provision of these rules and International Standard . Banking Practice (ISBP).

a.  'Honour' means to pay at sight if the Credit is available by sight payment.

b.  To incur (agree to become liable for) a deferred payment and pay at maturity if the Credit is available by deferred payment.

c.  To accept the Bill of Exchange (Draft) drawn by the beneficiary and pay at maturity if the Credit is available by acceptance.

Stages of Documentary Credit

1.    Concluding a sale contract

This is the preliminary stage to establish a documentary credit. At this stage, a sale contract is concluded between the buyer and tl seller where it is stipulated that the price be paid through _documentary credit.

2.    Requesting the opening of credit

At this stage, the buyer (applicant of the credit) requests the bank (issuing bank) to open the credit favoring the seller (beneficiary of the credit).

3.    Issuing credit and notifying the seller

At this stage, the bank issues and sends the documentary credit to the seller, either directly or through an intermediary bank (Advising bank).

4.    Executing the credit

At this stage, the seller submits the documents stipulated in the credit to the bank. The bank examines the documents with the conditions of the credit. If the documents conform to the conditions, the bank accepts these and delivers to the buyer with a request to make payment of the value or to give acceptance to pay on the date of maturity so that the buyer is able to receive the goods represented by the documents. If the documents do not confirm to instructions, the bank reserves the right to accept, reject or seek amendment of the documents.

5.             Coverage by Correspondents

6.              

^v If more than one bank participates in the execution of credit, the accounts are settled in accordance with the terms of coverage agreed upon between the banks.

Different Parties to a Documentary Credit

Normally the following parties are involved to a documentary credit.

a. The Issuing Bank: This is the Bank, who issues Documentary credit at the request of an applicant or on it's own behalf.

b. The Advising Bank: This is Bank, acting as Agent of the Issuing Bank, to advise the L/C, to the beneficiary.

c. The Confirming Bank gives the beneficiary, a double assurance to honor or negotiate a complying presentation. This is a third Bank undertaking to honor or negotiate, if the Issuing Bank fail to do so.

d. Negotiating Bank: This Bank purchase drafts and/or documents under a complying presentation. Usually this is the exporter's Bank who purchases the export documents by advancing or agreeing to advance funds to the beneficiary.

e. Reimbursing Bank: This is a Bank acting as Agent of the Issuing Bank, authorized to make payment or to honor       the reimbursing claim of the Negotiating Bank.

f.  The Transferring Bank : If the L/C is transferable, then the 1st beneficiary of the L/C may transfer the L/C to the 2nd beneficiary, through a Bank nominated by the Issuing Bank, this Bank is called The Transferring  Bank.

g.   The Applicant: Applicant means the party on whose request the credit is issued. Importer or buyer is the applicant of a Letter of Credit. Applicant must be the client of the Issuing Bank.

h.  The Beneficiary : Beneficiary means the party in whose favour a credit is issued. Exporter or Seller or the goods is the Beneficiary of a Letter of Credit.

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i.      Notify Party : The Party/Bank to whom the  arrival of shipment has to be notified or to be informed, is called Notify Party.

Mechanism of letter of credit

The following diagram brings out clearly the operation of letter of credit.

  

Shari`ah Permissibility of Documentary Credit

All Shari' ah permissible contracts are valid. Documentary Credit is a contract among the parties for import and export (buying and selling) of goods and assets. So, Documentary Credit against any halal goods or assets is valid. under Shari'ah point of view.

Sharjah Rulling on Documentary Credit

i.      It is permissible to stipulate in the contract that payment be made through a documentary credit.

ii.    It is permissible to secure international transactions using documentary credit provided that the secured transactions

       do not violate the rules the Shari'ah.

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iii.  When the contract stipulates that its interpretation issubject to UCPDC-600. INCOTERMS 2010 or the United Nation's Convention in  respect of the International sale of goods and the interpretation is restricted with a condition that it must not violate the rules of the Sharitah.

iv.It is permissible for the bank to charge actual expenses incurred in issuing documentary credit. It is also permissible for the bank to charge a fee for providing the requited services, whether such a fee is in the form of a lump sum or a certain percentage of the credit amount, provided that the duration of the credit is not considered in determining the commission. This rule applies to services rendered for both import and export credit, except the amendment of a rescheduling of the duration of the credit facility. In case of such amendment, it is permissible for the bank to charge only the actual expenses incurred and it will be a definite sum and not a percentage.

v.  The issuance of a credit facility should not involve riba. The rule equally applies to receiving or payment of commissions and expenses and in a situation where the bank acts as an intermediary in these respects, irrespective of whether the transaction is between the bank and its client (the orderer or beneficiary) or between the bank and other institutions and banks.

vi.    It is not permissible for the bank to accept the following types of guarantees

a.    Interest-based bonds,

 b.    Shares of companies that deal in prohibited activities and

 c.    Interest-based receivables.

iv.  It is permissible for the bank and the applicant for documentary credit to agree on investing the cash cover of the credit in accordance with Mudaraba principles.