As international trade
steadily grows in India, the question of securing payments from traders arises. Among other payment methods
, Letter of Credit
is a commonly used medium. The document serves as an assurance between the parties that payments will be made. A Revocable Letter of Credit is one such document that can be altered or terminated by the issuing bank without the permission and cooperation of the beneficiary or trading parties.
What is a revocable letter of credit?
A revocable LC provides no security and can be cancelled at any time, resulting in financial loss for the exporter. On the other hand, the importer is not in a safe position either, because the exporter can change the terms of the LC such as extending the time for sending goods1. These LCs are amendable at any point between the time the exporter ships goods and the time the issuing bank sends the necessary documents to the exporter. The issuing bank may also ask the exporter for additional documents that were not requested initially and can also change the expiry date of the LC. Despite that, the bank may still refuse to act as a mediator.
Understanding the functioning of revocable letter of credit with an example
Here’s an example to understand how a Revocable Letter of Credit works:
An international company called ABC Limited (importer) has a contract with a company outside of the said country (exporter) for three pieces of machinery. Because the shipment is global, the exporter requests a Letter of Credit to secure payment and the importer requests that their bank (issuing bank) issues a Revocable Letter of Credit and delivers it to the exporter. The exporter successfully transported the machinery, but when they contacted the issuing bank for payment, they refused to do it. When they called the importer, they stated that they did not have the funds to pay and were reliant on LC, making the exporter vulnerable to a scam. After additional investigation, the exporter realized that a Revocable LC allows the bank to deny payment and they must now collect the amount directly from the importer.
The above-mentioned example is fictional and for illustration of the concept only.
Types of revocable letter of credit
Revocable Letters of Credit can either be secured or unsecured. The importer is usually required to provide a personal guarantee or mortgage security for a secured Revocable Letter of Credit. For an unsecured Revocable Letter of Credit, the bank evaluates the importer’s creditworthiness2.
Difference between a revocable and irrevocable letter of credit
There are primarily three differences between revocable and irrevocable letters of credit2:
• Revocable LC is an unauthorized document that may be cancelled at any point during the LC
• Revocable LC is a significantly riskier choice for all parties involved because it does not guarantee payment to the recipient.
• A Revocable LC is the least commonly used instrument since it leaves both parties powerless.
• It cannot be cancelled and represents a definite promise by the issuing bank to pay the seller.
• Irrevocable LC certifies that the payment will be honoured by the issuing bank.
• Irrevocable LC is preferred over Revocable LC since it is an official agreement and guarantee.
Why does a bank revoke a letter of credit?
In general, the bank can cancel a revocable letter of credit in a few situations like deteriorating market conditions, financial crisis and political tension.
Why do importers issue a revocable letter of credit?
While many do not prefer to issue a revocable LC, it is commonly used when the contract between the parties lacks adequate conditions and terms or if either party lives in a climate of political turmoil or economic crisis. In this case, the bank cannot guarantee payments if the importer does not have a strong credit history or if they do not have a guarantee or collateral to provide as security to the bank. Furthermore, this LC is granted when the price of the products or services is expected to rise before the contract is executed.
Advantages of a revocable letter of credit
1. This LC puts the importer on the safe side. However, this creates a risk for the exporter as the importer can refuse to pay via this LC.
2. It is comparatively inexpensive. This transaction’s bank costs are significantly low.
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Published on October 29, 2022.