What is the procedure for a letter-of-credit transaction?
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A letter-of-credit is issued by a bank on the basis of a customer's credit worthiness (ability to repay the face amount of the letter of credit). The beneficiary of the letter of credit can then draw on the letter of credit as long as certain conditions are met. A bank's customer usually pays a fee for the letter of credit to be issued, and if the letter of credit is drawn upon, the customer will also pay an agreed-upon interest rate for the use of the funds.
The procedure for issuing a letter of credit is relatively straightforward. The customer of a bank or other financial institution requests a letter of credit of a specific type and amount. For example, an Irrevocable Letter of Credit is one in which, as long as the conditions spelled out in the letter of credit are met, the bank issuing the letter of credit must honor it and pay the face amount of the letter of credit to the beneficiary. Another very common type of letter of credit is the Standby Letter of Credit, which is used, in effect, to guarantee one party's obligations to another. In other words, if the party who provides the letter of credit fails to honor a financial obligation to the beneficiary of the letter of credit, the beneficiary may present the letter of credit to the issuing bank for payment.
In essence, a letter of credit is provided based on the bank's customer's ability (in the eyes of the bank) to repay the bank if the letter of credit is used. In effect, the letter of credit is very similar to a line of credit.
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