A letter of credit is issued to provide a financial guarantee to the seller. In some cases, the sellers may require further confirmation of the buyers’ credit. An advising bank provides the confirmation in addition to that of the issuing bank. It reduces the default risk of the buyer due to economic or financial reasons.
What is a Confirmed Letter of Credit?
A confirmed letter of credit is the second LC issued by a second bank to confirm the creditworthiness of the buyer. It acts as the backing plan for the first letter of credit issued by the buyer’s bank.
A letter of credit can embed several characteristics. All LCs are irrevocable by nature and non-transferrable. However, the sellers may ask for further financial security. The confirmation clause acts like a financial guarantee backing up the initial letter.
How Does the Confirmed Letter of Credit Work?
The confirmation clause is the undertaking by a second bank that works in addition to that of the issuing bank of the first LC. Usually, the seller’s bank acts as the confirming bank and issues the second letter of credit.
In large trade deals, the seller may ask the buyer to issue the confirmation LC. The buyer applies for the confirmed letter of credit in the same way as for the first one. The seller’s bank acts as the confirming bank usually. The second bank also approves the confirmed letter of credit as the first bank. The applicant’s (buyer’s) creditworthiness and the terms in the first letter of credit play the important role in approval for the confirmation LC.
The issuing bank approves the documentary credit after appraising the creditworthiness of the applicant. The confirmed LC also includes the same terms and conditions as in the first LC but may include some changes in the amount.
Key Points to Note with the Confirmed Letter of Credit
A confirmed letter of credit is required by the sellers usually. For convenience, the buyers approach the sellers’ banks for issuing the confirmation. As the trade deal already processes, there may exist certain differences in the confirmation letter of credit from the first LC.
Some of the key points with a confirmed Letter of Credit can include:
- The second letter of credit may only be issued for the partial or balance amount of the total trade deal.
- The issuing bank cannot issue the confirmation letter of credit.
- The second bank may require further collateral from the applicant i.e. the buyer.
- All the additional charges, interest, and service charges are incurred to the buyer for the confirmation LC as well.
The Approval of the Confirmed Letter of Credit
The second bank appraises the creditworthiness of the buyer in the same way as for any bank loan or the first LC. However, the approved first letter of credit works in favor of the applicant. As the confirming bank takes on the financial guarantee for the payment to the seller, it may require stricter approval criteria. Usually, the confirming bank requires further collateral or cash deposits from the buyer.
If the seller fails to deliver the goods on time, the applicant keeps control by not releasing the letter of credit. Similarly, if the buyer does not make the payments on time, the confirming bank releases the LC to the seller. The facility then acts as a bank loan to the buyer (applicant) with predefined repayment terms.
Example of a Confirmed Letter of Credit
Suppose a buyer in the UK makes a contract with a seller in the US. Once the trade terms are agreed upon by the two parties, the payment terms are negotiated. The Buyer in the UK would approach a local bank A in the UK to issue a letter of credit. By the time the sale completes, the seller in the US may ask for a confirmation from the buyer. The buyer may have to approach the seller’s bank to issue the confirmed letter of credit. The second will assess the buyer’s creditworthiness and issue the confirmation.
The second bank considers the first LC issued and the issuing bank’s appraisal of the applicant as well. With a confirmation attached, the risk of the default decreases for the seller. The confirmed letter of credit means the second bank takes on the financial guarantee if the first LC is not cleared.
In some cases, the seller may adjust the sale contract’s remaining balance in the confirmed LC and may accept the confirmed LC only.
Advantages of the Confirmed Letter of Credit
A confirmation from the second bank satisfies the seller’s requirements for a financial guarantee. It provides benefits to both parties in the international trades in certain ways.
- A confirmed Letter of Credit reduces the financial, economic, and political risk for the seller in international trades.
- It reduces the financial risk in large trade deals for the large remaining balances of the contract amounts.
- The seller receives the payment from the confirming bank in case of default for any reason from the buyer.
- The buyer can negotiate better trade terms and prices with the seller by issuing the confirmation.
- It makes complex trade deals possible where the macroeconomic or geographical factors affect the international trade transactions.
Disadvantages of the Confirmed Letter of Credit
Although the confirmation is desirable by many sellers, it is a complex procedure for many buyers. It comes with certain limitations for both parties as well.
- The confirmed letter of credit involves two distinct banks that approve the creditworthiness of the buyer.
- It can be difficult for the buyer to find a suitable second bank that satisfies the seller.
- The confirmation comes with additional charges and requires more time as well.
- The second bank may also request changes in the first letter of credit.
- In case of default for any reason, the buyer would settle the amount of confirmed LC with the confirming bank as a bank loan.
- Two banks may not appraise the creditworthiness of the applicant similarly.
A confirmed letter of credit provides financial security to the seller. The confirming bank makes the payment to the seller in case of default. The buyer can negotiate better trade terms by issuing a confirmation. However, it may be difficult for some buyers to obtain a confirmed Letter of Credit from the seller’s bank.