Why Letters of Credit Don't Work

Collections Training Resource
April 18, 2013 — 1,031 views  
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Letters of credit are documents issued by banks to ensure payment to the sellers based on fulfilling the conditions of the sale. These are common in international trade transactions where communication between time zones is quite difficult. The letters of credit ensure that applicant, beneficiary, issuing bank, and advising bank are all kept in the loop. But there are some disadvantages to both buyer and seller when using letters of credit (LOC).

Expensive and Time-Consuming

For the buyer, there are expenses for negotiating and some other fees that can make LOC quite expensive. Even the seller has fees associated with activities like negotiating and receiving, which can be more expensive than other forms of payment. The paperwork involved can also make letters of credit very cumbersome and time-consuming to produce, as it requires professionals to help you successfully navigate through the processes involved in the different stages of handling letters of credit. It also increases expenses involved when utilizing collection professionals to retrieve payment.

Potential Increase in Cost of Goods

Without using currency-hedging strategies, the cost involved can potentially increase as it is vulnerable to fluctuations in currency rate. That is, if the price has been already agreed upon in the seller's currency and the valuation of his currency increases, then the payment amount will be higher than expected. This might prompt him to withhold payment as the payment amount that was agreed upon has changed due to the increase in currency valuation. This will make the collection professionals' job extremely annoying and difficult while trying to negotiate and convince the borrower to pay up.

Risks Involved in Shipping and Payment

For the buyer, goods may not comply with the actual order and can be of inferior quality. In this case, if the seller doesn't admit to supplying inferior goods, you have to proceed to take action through legal methods, which will again add expenses to your bills. The seller is also at a risk of not being paid until there is strict compliance. A minor flaw in the conditions of the LOC can cause the bank to withhold payment. This will again create issues that might restrict the work of the collection professional.

Political and Financial Risks

The letters of credit are still susceptible to the political risk in their country of origin. It can also be influenced by the stability and strength of the bank that issues the letters of credit. When multinational companies have opened subsidiaries in countries that are open to political risks, actions made by the public or government could affect their cash flow. These actions could restrict the amount of legal allowance that a collections professional has in the country with regards to debt collection,

Reduced Control and Lower Available Business Credit

The buyer has absolutely no control over the shipping documents as it is the seller's bank that controls all the documents for shipping. This could increase the buyer's risk for financial loss. And these losses cannot be easily covered up by loans as the line of business credit is tied up with the expenses meant for the purchase of goods. This means that the payment may be stalled due to an inability to pay, making it tough for collections professionals to get back the money from the concerned borrower.

While the letters of credit have their disadvantages, they are helpful and important tools, and make international trade possible for both buyers and sellers. As long as you take some careful precautions during the business process, like carefully reviewing and understanding all the parts of the document, you should be able to do some excellent business with buyers or sellers from around the world. As for collection professionals, a carefully drafted LOC will help make their jobs easier and more productive.

Collections Training Resource