Credit instrument issued by a bank guaranteeing payments on behalf of its customer to a Beneficiary normally to a third party but sometimes to the bank's customer, for a stated period of time and when certain conditions are met. A letter of credit substitutes the bank's credit for the credit of another party, for example, an importer or exporter, who is authorized to write drafts up to a specified amount, payable by the issuing bank. Letters of credit are widely used in banking, originating with the commercial letter of credit in trade financing. Importers and exporters wanted assurances that merchandise delivered would be paid for by the buyer, a requirement that was met by obtaining a bank letter of credit. The buyer purchases a letter of credit, which is then forwarded to a correspondent bank in the city where payment is to be made. In trade financing, the bank drafts authorized under the issuing bank's letter of credit are frequently accepted by another bank, creating a Banker's Acceptance and become credit obligations of the accepting bank.
There are several major varieties of letters of credit, each serving a different purpose. A Credit cannot be cancelled before a specific date without agreement by all the parties involved, whereas a revocable letter of credit can be amended at any time by the issuing bank. A Confirmed Letter of Credit carries the endorsement of both the issuing bank and its correspondent, guaranteeing payment of all drafts written against it; an unconfirmed letter of credit, carries no such guarantee that a correspondent will honor drafts presented for payment. A Standby Letter of Credit is a contingent (future) obligation of the issuing bank to make payment to the designated beneficiary if the bank's customer fails to perform as called for under the terms of a contract. Standby letters, for this reason, are considered Off-Balance Sheet Liabilities in computing bank capital-to-asset ratios. See also Back-To-Back Letters of Credit; Credit Enhancement; Documentary Commercial Bill; Open Account; Red Clause Letter of Credit; Draft; Time; Traveler's Letter of Credit.