Letter of Credit Basics: Risks in Letters of Credit

Each international trade transaction carries a risk, lower or higher.

Some trade relationships might have been established for a long period of time between importers and exporters, whom are located in safe countries with sound financial backgrounds.

In such a scenario, we can talk about two professional partners, working for a win-win situation, both of them understanding its roles and responsibilities in order to complete the transaction in a good manner.

Concluding these kinds of transactions financially would not be a difficult task.

Now, I want you to think just an opposite scenario. Potential trade is about to initiate between an importer and exporter, whom has no enough knowledge about the counter party. Even more, at least one party is located in a politically unstable country.

What do  you think. Which payment method should be chosen to satisfy both parties under such extreme conditions?

Do you think that you can find a risk free payment method that you can rely on regardless of the surrounding conditions?

Above, I have tried to illustrate two different conditions effecting the payment selection decisions in international trade.

What sort of risks each letter of credit party has to bear in export and import transactions?

On this post, I will try to explain the risks associated with international payment methods in general.

Specifically, I will emphasize the risks in letters of credit for different parties perspectives.

What sort of risks are associated with international payment methods?

Political Risks:

Political risks in international trade, in simple terms, can be defined as the factors that are happened outside of importer's or exporter's control, preventing full or part of the payment of the goods reaching to the exporter or else preventing the delivery of the goods to the importer.

Political risks factors in export and import transactions.

Most common political risks are :

  • War, civil war, civil commotion, coups, other acts of politically-motivated violence, including terrorism
  • Foreign exchange controls
  • Restrictions on the foreign currency transfers

Fraud Risks:

As export and import transactions occur between companies located in different countries, the fraud risk in international trade is comparatively higher than the domestic trade. 

Additionally, fraudulent transactions in international trade possess more destructive risks to the exporters and importers, because of the fact that the volume of international trade transactions is generally bigger than domestic sales and also it is very hard to compensate losses resulted from fraudulent transactions. Fraudulent companies disappear very quickly, before you can reach them legally.

Fraud Examples:
  • Chinese supplier ships sands instead of polyurethane under cash in advance payment terms.
  • English supplier gets paid via forged documents under a letter of credit payment, even without making the shipment.
  • Exporter and importer scam issuing bank under letter of credit payment with a fictitious shipment. 

What are the Risks in Letters of Credit? 

In order to describe the risk in letters of credit accurately, it is imperative to clarify the specific risks that the letter of credit parties are exposed to.

On below image you can find the specific risks that each letter of credit party has to bear.

Applicant | Confirming Bank | Beneficiary | Issuing Bank | Nominated Bank | Risks

Applicant's Risks in Letters of Credit: Applicant is the importer in a commercial letter of credit transaction. Applicant's risks in a letter of credit transaction can be classified under shipment risks, issuing bank's failure risk and fraud risks.
  • Risks Related to Shipments: Short shipments, shipments of under quality goods and late shipments risks fall in this category.
  • Failure of the Issuing Bank: Failure of the issuing bank may result a double payment risk to the applicant. In case the issuing bank failed to pay the L/C amount, applicant may have to pay the credit amount to the beneficiary outside of the letter of credit, even if the applicant already paid the credit amount to the issuing bank.
  • Fraud Risks: Applicants are exposed to fraud risks, that are commonly originated from the acts of the beneficiaries. This scenario becomes reality if the beneficiary gets his money from the confirming or issuing bank against forged documents. 
Beneficiary's Risks in Letters of Credit: Beneficiary means the party in whose favor a credit is opened. Beneficiary's risks in a letter of credit transaction can be classified under discrepant documents risks, fraud risks, non-payment risks (due to sanctions, political risks etc.)     
  • Discrepant Documents Risks: If the banks figure it out that the documents are discrepant, then beneficiaries can only reach the payment upon applicant's acceptance of the documents. 
  • Fraud risks: Applicants can receive funds under letters of credit via forged documents by shipping under quality goods or even worse shipping nothing at all. 
  • Non-Payment Risks (Due to Sanctions, Political Risks etc.): Beneficiaries make sure that they comply with the international regulations including UN, EU and US embargoes.   
Issuing Banks's Risks in Letters of Credit: Issuing bank is the entity, which gives the main conditional payment guarantee to the beneficiary. As a result, issuing bank is more vulnerable to the risks in letters of credit transactions than any other parties involved.
  • Insolvency Risk of the Applicant: Issuing bank may not be able to recover the credit amount that has already paid to the beneficiary, if applicant becomes insolvent after issuance of the letter of credit.
  • Fraud Risks: Beneficiary and applicant may act together to scam issuing banks under letter of credit transactions.
  • Political Risks: Issuing bank may not be able to honor its payment obligation due to various political risks. Most recent examples are sanction clauses inserted into letters of credit.
Confirming Bank's Risks in Letters of Credit: Confirming bank means the bank that adds its confirmation to a credit upon the issuing bank's authorization or request. 
  • Non-reimbursement Risks: A confirming bank is irrevocably bound to honor or negotiate as of the time it adds its confirmation to the credit. A confirming bank's main risk is the non-reimbursement risk, which means that the confirming bank could not get the credit amount from the issuing bank, although it has already paid it to the beneficiary.