Documentary credit is an essential part of the export process.
The documentary credit system has been used for over a hundred and fifty years, and still
plays a major role in international trade.
Letters of credit have been estimated to represent more than US$100 billion in banking obligations annually.
At least 60 per cent of commodity trading is conducted through letters of credit.(Source: Documentary Risk in Commodity Trade, UNCTAD/ITCD/COM/Misc.31, Page:1)
Although letter of credit is a balanced payment method in terms of risk issues for both exporters and importers, each letters of credit party bears some amount of risk; higher or lower.
As I have explained on my previous post, letters of credit transactions are handled by banks, which make banks one of the parties that bears risks in l/c transactions in addition to exporters and importers.
Risks in letters of credit can be discussed under four groups; general risks, risks to the applicant, risks to the beneficiary and risks to the banks.
On this post each risk group will be examined in detail with in real life examples.
General Risks in Letters of Credit:
Country Risk: (Political Risk)
The first risk factor that can be mentioned in the general risks group is the country risk or the political risk.
Let us assume that we are an exporter located in a country X and we have a customer from the country Y.
Our customer, which is from the country Y, opened a L/C in favor of us. We have checked the L/C conditions and they seem workable.
We have produced and shipped the order as per the L/C and transmit the required documents to the issuing bank before the expiry date.
The issuing bank found our presentation complying and informed us that they will be honoring our payment claim at the maturity date.
However, before the maturity date due Country Y has changed its export regime, which makes it impossible for the issuing bank to honor our presentation.
This illustrative is a good example of a country risks.
Other examples of country risks are mass riots, civil war, boycott, sovereign risk and transfer risk.
Country Risk Example: During Libyan Civil War in year 2011, hundreds of exporters could not receive their payments as international community blocked Libyan Government’s funds in major currencies such as US Dollars and Euros.
As we have described before all conditions stated in a letter of credit must be connected to a document, otherwise banks will disregard such a condition.
In addition, banks deal with only documents but not goods, services or performance to which the documents may relate.
This feature of the letters of credit is the source of the fraud risk at the same time.
As an example, a beneficiary of a certain letter of credit transaction can prepare fake documents, which looks complying on their face, to make the presentation to the issuing bank.
As the documents are complying on their face, the issuing bank may honor the presentation and in this case, the applicant must pay to the issuing bank for the goods it will never be receiving.
Beneficiaries of L/Cs are also open to significant amount of fraud risks.
This happens if an applicant issues a counterfeit letter of credit. In this case, the beneficiary never receives its payment for the goods it has shipped.
Fraud Risks Example: UK steel giant, which was very close to bankruptcy at the time when the business occurs, has received funds under a letter of credit issued from Algeria via fake documents.
Risks to the Applicant:
In a letter of credit transaction, main risk factors for the applicants are non-delivery, goods received with inferior quality, exchange rate risk and the issuing bank’s bankruptcy risk.
Risks to the Beneficiary:
In a letter of credit transaction, main risk factors for the beneficiaries are unable to comply with letter of credit conditions, counterfeit L/C, issuing bank’s failure risk and issuing bank’s country risk.
Risks to the Banks:
Every bank in a L/C transaction bears risks more or less. The risk amount increases as responsibility of the bank increases.