The Role of Banks and Financial Institutions in Letter of Credit Transactions

In the intricate world of international trade, where goods traverse borders, and business relationships span continents, the Letter of Credit (LC) emerges as a linchpin, offering security and trust in financial transactions. Banks and financial institutions are at the heart of this mechanism, orchestrating a delicate dance to ensure the smooth flow of commerce.

What is a Letter of Credit?

A financial document used in international trade finance transactions is a letter of credit (LC). A bank issues a written guarantee on behalf of an importer or buyer to pay a seller, subject to the seller fulfilling the terms and conditions mentioned in the letter of credit, for a predetermined amount.

Here’s how a typical letter of credit transaction works:

  • Agreement between Buyer and Seller: The buyer and seller agree to use a letter of credit as the payment method for the transaction.
  • Opening the Letter of Credit: The buyer (importer) approaches a bank to open a letter of credit in favour of the seller (exporter). The bank, often referred to as the issuing bank, agrees to issue the letter of credit.
  • Terms and Conditions: The letter of credit includes specific terms and conditions the seller must meet to receive payment. These conditions often include documents that prove the shipment of goods, such as invoices, bills of lading, and inspection certificates.
  • Notifying the Seller: Once the letter of credit is issued, the issuing bank notifies the seller and provides details of the conditions that must be met for payment.
  • Shipment of Goods: The seller ships the goods to the buyer and prepares the required documents as specified in the letter of credit.
  • Presenting Documents to the Bank: The seller presents the required documents to the bank, known as the negotiating or advising bank. This bank examines the documents to ensure they comply with the letter of credit terms.
  • Payment to the Seller: The bank pays the seller if the documents meet the specified conditions. The issuing bank then reimburses the negotiating bank.

For both the seller and the buyer, using a letter of credit helps reduce risk. The buyer is guaranteed payment only upon presenting the necessary documentation, and the seller is guaranteed payment upon fulfilment of the requirements. This financial instrument provides a level of security in trade finance transactions where parties may not have established a trust relationship.

Role of Banks in Issuing Letter of Credit

When a buyer and seller agree to engage in a letter of credit transaction, the buyer’s bank, also known as the issuing bank, plays a pivotal role in initiating the process.

The issuing bank undertakes the responsibility of issuing the letter of credit in favour of the seller, thereby assuring the seller of payment upon compliance with the terms and conditions stipulated in the LC. This crucial step provides the seller with the confidence to proceed with the shipment of goods, knowing that the issuing bank secures payment.

Role of Banks in Advising Letter of Credit  

The buyer’s bank will typically send the credit letter to the seller via an advising bank in the seller’s country after it has been issued. To convey the terms and conditions of the LC to the seller, the advising bank acts as a broker.

Additionally, the advising bank verifies the authenticity of the LC and ensures that it aligns with international standards and banking practices. This step adds a layer of credibility to the transaction and instils trust between the buyer and the seller.

Role of Banks in Confirming Letter of Credit

In some cases, particularly when the seller is unfamiliar with the buyer’s bank or has concerns about the buyer’s creditworthiness, the seller may request a confirmed letter of credit. In this scenario, a confirming bank, typically located in the seller’s country, adds its own undertaking to honour the letter of credit, thereby providing an additional layer of security to the seller.

The confirming bank effectively guarantees the payment to the seller, independent of the buyer’s bank. This level of assurance can be particularly valuable in mitigating the risk of non-payment, especially when dealing with unfamiliar or high-risk trading partners.

Role of Banks in Examining Documents

Upon the presentation of documents by the seller in compliance with the terms of the letter of credit, the role of banks extends to meticulously examining these documents to ensure their conformity with the requirements specified in the LC. This scrutiny is essential to verify the accuracy and authenticity of the presented documents, including invoices, bills of lading, and inspection certificates.

The banks act as impartial evaluators, meticulously reviewing the documents to ascertain their compliance with the terms of the LC, thus safeguarding the interests of both the buyer and the seller.

Role of Banks in Effecting Payment  

Once the documents are found to conform with the LC, the banks proceed to effect payment to the seller as per the terms of the letter of credit. The issuing bank is obligated to honour the payment, provided that all the conditions stipulated in the LC have been met. This step ensures that the seller receives payment for the goods or services rendered while also upholding the integrity of the letter of credit transaction.

Role of Banks in Handling Discrepant Documents

If discrepancies are identified in the documents presented under the letter of credit, the banks are tasked with managing this situation fairly and transparently.

The banks communicate any discrepancies to the parties involved and work towards resolving the issues through negotiation or amendment of the relevant documents. This demonstrates the crucial role of banks in ensuring that any discrepancies are addressed promptly and equitably, thereby upholding the integrity of the letter of credit transaction.


The involvement of banks and financial institutions in letter of credit transactions is indispensable to the smooth functioning of international trade. From the issuance and advising of the LC to the examination of documents and the facilitation of payment, banks play a multifaceted role in safeguarding the interests of both buyers and sellers.

Their expertise, credibility, and adherence to international banking standards form the bedrock of trust and security in letter of credit transactions. As global trade continues to expand, the pivotal role of banks in letter of credit transactions remains paramount in ensuring the reliability and efficiency of cross-border trade arrangements.