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Nov 16, 2011 - 3 minute read - Comments - banking

Understanding An Import Letter of Credit

An import letter of credit (import documentary credit) is issued by a bank at the request of an importer. The letter of credit states that the bank will pay a specified sum of money to a beneficiary, normally an exporter, on presentation of particular, specific documents.

If you are importing goods into Canada, you can go to your bank to request an import letter of credit. The bank will evaluate your credit worthiness much like it would for a loan. This is because it is making a promise to pay the exporter of the goods on your behalf. The bank wants to make sure that in the end it can get the money from you. For importers who do not have a long history with the bank or those who have newer businesses that don’t have significant assets, the bank may require collateral in support of the letter of credit. There will be a fee for this letter of credit ranging from 0.5% to 2% of the letter of credit amount.

The letter of credit is a promise from the importer’s Canadian bank to pay the exporter of the goods as long as they are shipped in accordance with specified instructions and conditions. A contract is created between the Canadian bank and the exporter of the goods.

The Canadian bank will sent the letter of credit to the exporter’s bank. The exporter’s bank will then let the exporter know that it is ok to ship the goods. The exporter will draw a draft against the Canadian bank in accordance with the terms of the letter of credit, attach the required documents, and present the draft to his own bank for payment.

The exporter’s bank will send the letter of credit and associated documents to the Canadian bank for payment. If all the terms and conditions in the letter of credit have been complied with (meaning the goods have been delivered) the Canadian bank will pay the exporter’s bank. The Canadian bank will request payment from the importer.

What this series of transactions does is trade the creditworthiness of the importer and the exporter, who may not know or trust one another, for the creditworthiness of their banks. The two banks will presumably know and trust another and have had many other dealings with each other. The importer and exporter each trust their own banks, and the banks trust each other. This makes the transaction much safer than if the importer and exporter dealt with each other directly.

If you are importing significant quantities of product as part of your business, you should speak to your bank about setting up one these letter of credit facilities. One failed transaction could be very costly. Off-setting the risk of this may well be worth the cost of a letter of credit.