Letters of credit are a source of financial security for the trade parties. A letter of credit enables payments and offers financial security in international transactions. There are two banks involved in completing the process. An issuing bank from the buyer side and a nominated bank from the seller side. A recourse attached to any debt instrument or a letter of credit lowers the risk of banks.
Definition – A Letter of Credit with Recourse
A letter of credit with recourse means if the issuing bank refuses to pay to the nominated bank, the nominated bank will claim the reimbursement with interest from the customer.
A non-confirmed letter of credit can be negotiated between a customer and its nominated bank to be with recourse. A confirmed letter of credit cannot be with recourse unless otherwise specified with special conditions.
Definition – A Letter of Credit without Recourse
A letter of credit without recourse means the nominated bank does not have a recourse if the issuing bank fails to make the payment or does not accept the documents.
If the confirming bank and the nominated bank are the same, then there will be no recourse with a letter of credit.
Working Mechanism of a Letter of Credit – With and Without Recourse
Recourse is a legal right to the lender to claim the pledged asset if the borrower fails to make the repayment of borrowed money. Recourse can be negotiated with any lending instrument. It works in a non-confirmed and negotiable letter of credit as well.
When two parties enter into a trade agreement, they can decide on a letter of credit as the source of payment. The buyer approaches the bank to issue a letter of credit to the beneficiary (seller). The issuing bank issues a letter of credit after assessing the creditworthiness of the applicant. An issuing bank will keep an asset such as cash as collateral against issuing the letter of credit.
The Issuing bank sends the letter of credit to the nominated bank of the beneficiary. The seller can then proceed with the manufacturing and shipping of the goods. Once the seller fulfills the trade contract terms and ships the goods, it approaches the nominated bank. The nominated bank releases the funds to the seller before it receives the money from issuing bank of the buyer.
If under any circumstances, the issuing bank does not accept the letter of credit or shipping documents or fails to make the payment, the nominated bank will use the recourse. It means the nominated will seize the collateral or cash owned by the seller. A recourse gives a legal right to the bank to take other assets owned by the borrower, not just the pledged ones as collateral. The bank can recover the full amount of the letter of credit advances and the interest charges.
In case of a confirmed letter of credit, there will be no recourse attached to a letter of credit. In that case, even if the issuing bank refuses to make the payment, the issuing bank cannot use the recourse rights.
Key Points to note in With and Without Recourse Letters of Credit
A letter of credit can be issued with or without recourse. However, the nominated bank can negotiate the terms with the exporter to decide on the form of a letter of credit.
Here are some key points to note in a letter of credit with and without recourse.
- A non-confirmed and non-transferable letter of credit can be with recourse.
- The issuing bank must issue a letter of credit that is negotiable and non-transferable for recourse.
- A recourse gives a legal right to the nominated bank to claim the assets owned by the beneficiary in case the issuing bank fails to make the payment.
- A confirmed letter of credit comes without a recourse.
- The nominated bank may keep the original letter of credit and shipping documents such as the bill of lading for security.
Suppose a buyer company Green Star in Germany enters into a trade contract with Blue Tech in China. Both companies arrange a trade contract worth $ 500,000. Green star makes an advance payment of $ 200,000 and the remaining balance is decided to be paid through a non-confirmed letter of credit.
Green Star will approach a bank ABC in Germany to issue a letter of credit. Blue Tech will nominate a bank XYZ in China. Blue tech and XYZ bank can negotiate the terms of Letter of Credit to be with or without recourse processing. Once Blue Tech completes the manufacturing and ships the goods, it presents the documents to XYZ and claims the payment. XYZ Bank clears the payment for Blue Tech and forwards the shipping documents and LC to ABC bank in Germany.
If ABC bank does not accept the shipping documents, defaults, or Green Star defaults on the payment, XYZ can use the recourse. XYZ bank can claim a right to the assets owned by Blue tech for the repayment of advanced funds and interest.
If the Letter of credit would have been issued without recourse, XYZ bank could only claim the pledged asset as collateral.
Advantages of a letter of Credit – With and Without Recourse
A letter of credit secures the financial interests of both parties in a trade contract. A recourse provides several benefits to the issuing and nominated bank.
- A recourse letter of credit secures the nominated bank’s financial interest as it gives the bank right to claim the borrower’s assets.
- A letter of credit with recourse is secured and hence comes with lower costs.
- A letter of credit without recourse requires confirmation that usually involves a third bank as confirming bank.
- The letter of credit with recourse helps the exporter to receive funds quickly.
- The exporter can use an LC with recourse to access funds and make payments to its suppliers.
Disadvantages of a letter of Credit – With and Without Recourse
A letter of credit with and without resource can come with certain limitations as well:
- A letter of credit with recourse is a risky option for the exporter.
- If the borrower seeks confirmation from the importer, it can offer its bank the right to recourse.
- The arrangement with a letter of credit with recourse can be complex, as the nominated bank will require original shipping documents in possession.
- A letter of credit without recourse is unfavorable for the nominated bank and may incur higher lending costs.
Recourse is a legal agreement that gives the nominated bank a right to the exporter’s assets if the issuing bank fails to make the payment for some reason. A recourse makes the LC payment process secure for the nominated bank. While a letter of credit without recourse is usually confirmed and reduces the risk for the exporter.