The Role of Letters of Credit in Payment Transactions
Abstract
Rules governing letters of credit rest on the premise that they provide a highly certain method of payment to a seller of goods. Thus, the law and the terms of the letter of credit make the obligation of the issuer to provide payment to the seller independent of the purchaser's performance on the underlying contract. Hence, the issuer is obligated to pay the seller upon presentation of specified documents, without regard to the seller's actual compliance with the contract. In practice, however, most drafts on letters of credit in such transactions do not comply with the letter of credit. To get a sense for the actual rate of compliance, I have collected data on 500 transactions – 100 each from five U.S.-based banks with large letter-of-credit portfolios. That data shows that the drafts comply in less than 25% of the cases. Thus, a large share of drafts of letters of credit are honored only after the bank consults with the purchaser and obtains the purchaser's consent to honor the draft. At first glance, that process seems to remove completely the force of the letter of credit, by leaving the seller's ability to obtain payment to the will of the purchaser.
The question, then, is why parties in the industry believe so strongly that the letter of credit operates to provide an enforceably independent payment mechanism for the seller. I bolster the raw data from the transactions with interviews with letter-of-credit executives at those five institutions, as well as interviews with five other banks (two U.S.-based banks and three Japan-based banks) about how they deal with discrepant presentations on letters of credit. The data and interviews show that reputational intermediation provides a significant reason for the letter of credit, entirely separate from any credit enhancement from the bank's promise to pay. The paper discusses a number of different scenarios, but the most common one is illustrative. In that scenario, an exporter selling goods to a foreign importer obtains a letter of credit issued by a bank in the country of the foreign importer. The willingness of the bank to issue the letter of credit sends a significant signal about the reliability of the overseas buyer. In particular, it suggests implicitly that the buyer is unlikely to respond opportunistically to a discrepant draft on the letter of credit. My interviews with American and Japanese letter-of-credit executives indicate that executives in both countries would terminate relationships with customers – even profitable customers – if those customers opportunistically relied on discrepant documents to refuse payment in letter-of-credit transactions.
The last question is why the seller chooses to use the foreign bank as an intermediary instead of verifying the reputation of the foreign buyer directly. The answer is that it generally is easier to verify the reputation of a foreign financial institution than a foreign merchant of a more general nature. Most countries have relatively few banks, and very few banks that participate in letter-of-credit transactions. Also, banks are much more likely than other businesses to be sufficiently regulated to ensure the reliability of their public financial statements. In sum, because it is easier for the seller (aided by its own bank in its own country) to assess the reliability of the foreign bank than the reliability of the foreign buyer, the seller uses the foreign bank as a reputational intermediary.